Negative amortization occurs when the monthly payments a homeowner makes toward their mortgage are not enough to cover the interest charges, let alone a portion of the principal amount. As a result, the outstanding balance on the loan increases, instead of decreasing, with each payment.
This means that even if a homeowner makes their usual payments, the unpaid interest each month will get added to their loan amount. As things progress, they could eventually owe more than the value of the home. This can lead to higher interest payments over the life of the loan and a longer repayment period.
Negative amortization is a risk for both borrowers and lenders, as it may lead to default and foreclosure. It is important for homeowners to understand the terms and conditions of their mortgage agreement, and to consider the long-term financial implications of their monthly payments and changing interest rates.
Let’s use an example of a homeowner with a variable interest rate mortgage and a fixed payment. Over time, their interest rates increase significantly until the homeowner’s fixed payment does not cover their monthly interest.
Each month, the portion of unpaid interest is added to the homeowners outstanding loan. This creates negative amortization as their outstanding mortgage balance increases each month, meaning their amortization period increases instead of decreases.
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