What Is the Accounting for a Negative Amortizing Loan?
A negative amortizing loan is generally a big red flag in a business's accounting records -- both for the entity that owes the loan, as their debt is increasing, and for the company that lends it, as it's thought to be a less reliable source of interest income than a loan whose balance is decreasing. In either case, it's important to be on the lookout for negative amortization and understand the accounting procedures required to properly report this situation.
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Basics of Negative Amortization
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A negative amortizing loan, or NegAm loan, is a situation where a borrower fails to pay off the total interest due on a loan, which can result in an increase in the total amount owed. This is a problem sometimes associated with adjustable rate mortgages and other financial instruments where the total amount of interest can increase over time. Interest that is left over after a payment is added to the borrower's principal, which means that the borrower is essentially liable for more debt than he originally took on.
Recognizing Interest Income
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Lenders generally account for all of the interest on a loan as a receivable income, which means that income is recognized before they receive a cash payment from the borrower. Banks holding a negative amortizing loan typically account for the loan's full interest as receivable income and post this interest to their earnings, even though some financial analysts believe negative amortizing loans are doubtful accounts -- debts that are not likely to be paid, according to industry expert Doris Dungey.
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Challenges with NegAm Accounting
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The problem with accounting for negative amortizing loans as regular interest income is that financial analysts tend to believe these loans are highly doubtful. Borrowers with an increasing loan balance are much more likely to default than those whose loans are decreasing. Negative amortization could increase the size of a loan to the point where a borrower is simply unable to ever pay it off, which means the bank will be forced to recognize a major bad debt expense in the event of default. For this reason, financial professionals like Jonathan Weil, a columnist at Bloomberg, and James Grant, a credit market analyst, believe that recognizing interest income from negative amortization could lead to higher earnings statements than are realistic.
Accounting as a Borrower
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Borrowers account for all long-term debt transactions as notes or loans payable. Mortgages are usually amortized over many years, so they're considered a long-term liability. All payments on a mortgage are debited against the long-term debt, with interest payments recognized in an equity account called interest expense. In the case of a negative amortizing loan, only an interest expense transaction is recorded, as the payment is only subtracted from interest and not principal. Any remaining interest owed to the lender is credited to the mortgage account, so that the borrower's total recorded debt obligation increases.
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References
- FinAid: Benefits of Paying the Interest on Student Loans During the In-School and Grace Periods
- Federal Reserve Board: Consumer Handbook on Adjustable Rate Mortgages
- Calculated Risk: Accounting for Negative Amortization
- Real Estate Finance and Investments; William Brueggeman and Jeffrey Fisher
- Bloomberg Business Week: Nightmare Mortgages
- Cliffs Notes; Accounting Principles II--Mortgages Payable; 2011
Resources
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