Should You Fear Negative Amortization?

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 "amortization."

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 amortization.

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 payment.

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.

In Is 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 payment.

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.

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