November 20, 2000
" When my real estate agent
turned me over to a loan officer, he said 'Don't put Charlie into an ARM
(adjustable rate mortgage) involving negative amortization', and the loan
officer said 'Don't worry'. I didn't want to confess my ignorance, but what is
negative amortization and why should I be afraid of it?"
Negative amortization arises when the
mortgage payment is smaller than the interest due and that causes your loan
balance to increase rather than decrease.
Your mortgage payment has two parts: an
interest payment covering the interest due for that month, and a principal
payment. The principal payment reduces the loan balance and is called
For example, the monthly mortgage
payment on a 30-year fixed-rate loan of $100,000 at 6% is about $600. In the
first month, the interest due the lender is $500, leaving $100 for amortization.
The balance at the end of month one would be $99,900.
The $600 payment is a "fully
amortizing" payment. If you continue to pay that amount every month during
the period remaining to term and the interest rate does not change, the loan
will be paid off at term.
A $550 payment would be partially
amortizing, leaving a balance at the end of the loan�s term. A $500 payment
would just cover the interest � there would be no amortization.
If your payment is only $400, it would
fall short of the interest due by $100 and the loan balance would rise to
$100,100. In effect, the lender makes an additional loan of $100, which is added
to the amount you already owe. This rise in the loan balance is called negative
Negative amortization can only arise
on ARMs with one or more of the following features:
- The initial payment does not
cover the interest due, as in the example. The purpose of such a feature is
to increase affordability.
- The interest rate adjusts more
frequently than the monthly payment. The purpose of this feature is to avoid
frequent changes in your monthly payment.
- Changes in the monthly payment
are capped, usually at 7.5%. The purpose is to avoid large changes in the
But these borrower-friendly features
have a downside. If interest rates rise persistently, the equity in your house
will decline rather than rise unless the negative amortization is offset by
house appreciation. In addition, negative amortization must be repaid, which
means that your payment is going to rise in the future. The larger the negative
amortization, the greater will be the increase in the future payments that will
be required to amortize the loan in full.
"When I expressed concern about
negative amortization, my loan officer said not to worry, that my ARM limits the
amount to 25% of the original balance. Is he right?"
He is correct that negative amortization is
limited, but the implication that the limit protects you is misleading, at best.
The limit is designed to protect the lender, not you.
If you ever reach the limit, the lender
immediately raises the mortgage payment to the fully amortizing level,
regardless of how large an increase that might be. A negative amortization cap
overrides a payment adjustment cap.
The negative amortization cap would be
reached only if interest rates increase persistently over a long period.
a 3.95% ARM a Good Deal?, I examine what would happen to the payment and to
the loan balance on a negative amortization ARM if interest rates rose by 1% a
year for 5 consecutive years. This ARM had monthly rate adjustments, annual
payment adjustments capped at 7.5%, and an initial payment below the interest
The payment on this ARM would rise by
7.5% in months 13, 25, 37, 49, 61 and 73. But in month 82, two months prior to
the next scheduled payment adjustment, the loan balance would hit 125% of the
original balance. At that point, the payment would jump by 77%.
I concluded that while this was an
unlikely event, it was not impossible.
ARMs that allow negative amortization
can increase home affordability, and may also offer lower interest costs than
other mortgages, provided that interest rates don�t rise persistently. As with
most everything else in finance, the benefits come packaged with risk.
Copyright Jack Guttentag 2002