How to Understand Negative Amortization

Investing in real estate is not as easy as it first seems. In reality there are a lot of things that can happen within the scope of a mortgage that can dramatically increase your monthly payments and even increase the overall size of the loan. Negative amortization is one of these things.

Difficulty: Easy

Instructions

1. Define "negative amortization." Negative amortization occurs when the borrower pays less than the actual amount of interest owed to the lender each month.

2. Learn how this can happen. If you have an adjustable rate mortgage and your mortgage contract has a payment cap clause in it that limits how much your monthly payment can be raised after each adjustment period, you may end up paying less then is actually owed in interest. Negative amortization occurs in this situation because the payment cap limit only affects the size of the hike in your monthly payment; it does not put a cap on the interest that you can be charged. As a result, your payment may not be raised enough to cover the principal and the new higher interest rate. Negative Amortization is often associated with ARMs, but it can occur in other loan programs as well.

3. Learn about the restrictions associated with negative amortization. If your mortgage allows for negative amortization, it will also probably limit how long you can use negative amortization before your loan needs to be “recast.” Recast is basically just resetting your loan by fully amortizing it based on the new interest rate, outstanding balance still owed and unpaid interest that accumulated during the negative amortization period. Most mortgages will cap your negative amortization period at five years.

4. Learn about the term "cap." A cap is basically a maximum rate of change that your monthly payments or interest rates can be adjusted to.

5. Learn about the term "life cap." The life cap is the limit set on the mortgage's interest rate when it is recast. This amount is usually set at about 9.95%, however, the terms set out in the mortgage contract will define the actual life cap.

6. Learn about the term "payment options." Like most other loans, a loan that allows negative amortization has four basic payment options: 30 year payment, 15 year payment, minimum payment and interest-only payment.

7. Learn about the term "recast." As mentioned above, recast means that negative amortization is stopped and the loan is fully amortized based on the remaining capital due, the outstanding interest that is due and on the new interest rate.

8. Learn about the term "stop." Stop is simply when the negative amortization payment schedule ends and a recast is initiated.

Tips & Warnings

• Ask your lender to explain negative amortization.
• There is a lot of information about negative amortization available online.
• Negative amortization is best suited for markets where the interest rates are going down.
• Negative amortization can be very risky in markets where the interest rate is increasing.
• Negative amortization is not right for every investor.
• Make sure you know how negative amortization will impact your monthly payments before signing your mortgage contract.