Negative Amortization

What Is Negative Amortization?

Negative amortization is a loan repayment situation in which the payment made is smaller than the interest that accrues during the period, so the unpaid portion is added to the loan's principal balance. Instead of shrinking, the amount owed grows. The term is the opposite of the normal process of amortization, in which each payment reduces both interest and principal until the loan reaches zero.

How It Works

Interest on most loans is charged on the outstanding balance. If a required or chosen payment does not cover that interest, the shortfall is typically capitalized, meaning it is folded into the principal. Future interest is then calculated on the larger balance, so the debt can compound.

Unpaid interest = Interest due − Payment made

Negative amortization appears most often in adjustable-rate mortgage products that offer a minimum payment option, and in some student loan arrangements where unpaid interest capitalizes. As the balance grows, the borrower's loan-to-value ratio can rise even if the property's value stays flat.

An Example

Suppose a borrower owes 200,000 at a 6 percent annual rate. Monthly interest is about 1,000 (200,000 × 0.06 ÷ 12). If the borrower makes a payment of 800, the 200 shortfall is added to the balance, which becomes 200,200. The following month, interest is charged on 200,200, so the gap can widen further.

Advantages and Risks

The main appeal is a lower payment in the short term, which can ease cash flow. The drawbacks are significant. The balance rises instead of falling, so the borrower may owe more than the original loan amount and more than the asset is worth. Many loans with this feature also reset to fully amortizing payments after a set period, which can cause a sharp increase in required payments. Because of these risks, many jurisdictions regulate such features, and understanding how the balance changes under each payment option is central to evaluating these loans.