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Negative Amortization

DEFINITION

Monthly mortgage payment structure where payments do not cover the interest rate payments thereby increasing the principal balance each month.

EXPLANATION

Negative amortization is when the loan payment does not cover the interest due on the mortgage payment. The mortgage balance (interest not being paid) will therefore be added to the loan balance.

To pay all the interest over the life of the loan, the unpaid interest will be added to the principal balance. This negative amortization payment schedule will continue for five to ten years depending on how long it takes for the borrower’s income to rise. Monthly payments will remain the same after the five to ten-year period until the loan is paid off, refinanced, or the property is sold.

While negative amortization or, neg am programs, as they are commonly known, increase the borrower’s principal balance, thereby reducing or eliminating the borrower’s equity, the program does allow borrowers who would otherwise not qualify for traditional loans to buy a house.

Types of Negative Amortization Programs

There are various negative amortization programs. The FHA has a program called the graduated payment mortgage (GPM). The GPM is created for borrowers whose income will likely rise in the future. This program only applies to borrowers who own or are going to purchase a single family residence. It does not apply to investment, commercial or industrial real estate. Because the GPM mortgage is predicated on the fact that a borrower’s income will rise, the mortgage payment for the program does not cover interest payments, which means a graduated mortgage program is a negative amortization mortgage.

Drawbacks to Negative Amortization Programs

The fact that negative amortization programs are risky and put homeowner’s in precarious financial situations because payments in such a program increase the loan amount, and over time the monthly payment because of an increased  principal balance, lenders are required to accept more than the negative amortization payment if the borrower can do so. Lenders must disclose this to borrowers when deciding to choose the payment option. It is unlawful for a lender to mislead a borrower regarding negative amortization programs. Lenders must disclose the fact that negative amortization programs increase the loan amount and do not cover principal or interest payments.

Although a borrower may make lower monthly payments in the short-term, negative amortization increases the overall loan amount and makes future mortgage payments more costly. This challenging financial position could eventually result in foreclosure.

Benefits of a Negative Amortization Program

Negative amortization programs offer borrowers who typically would not have the ability to afford a mortgage the financial power to afford mortgage payments. Because neg am payments are much lower, borrowers with limited income or unforeseen circumstances can benefit from the lower payments. This program is only advised for borrowers that foresee their income to rise in the near future. What is common for a borrower to do is utilize a negative amortization particularly when the buyer purchases the property at a discount and can sustain the principal balance increasing.

Negative amortization programs are most typically utilized by investors that wish to have the cheapest mortgage payments until the point in which the property is developed. This proves valuable for investors who limited financial capital and those that own multiple properties.

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