In finance, negative amortization (also known as NegAm, deferred interest or graduated payment mortgage) occurs whenever the loan payment for any period is less than the interest charged over that period so that the outstanding balance of the loan increases.[1] As an amortization method the shorted amount (difference between interest and repayment) is then added to the total amount owed to the lender. Such a practice would have to be agreed upon before shorting the payment so as to avoid default on payment. This method is generally used in an introductory period before loan payments exceed interest and the loan becomes self-amortizing. The term is most often used for mortgage loans; corporate loans with negative amortization are called PIK loans.
Amortization refers to the process of paying off a debt (often from a loan or mortgage) through regular payments. A portion of each payment is for interest while the remaining amount is applied towards the principal balance. The percentage of interest versus principal in each payment is determined in an amortization schedule.
Negative amortization only occurs in loans in which the periodic payment does not cover the amount of interest due for that loan period. The unpaid accrued interest is then capitalized monthly into the outstanding principal balance. The result of this is that the loan balance (or principal) increases by the amount of the unpaid interest on a monthly basis. The purpose of such a feature is most often for advanced cash management and/or more simply payment flexibility, but not to increase overall affordability.
Neg-Ams also have what is called a recast period, and the recast principal balance cap is in the U.S. based on federal and state legislation. The recast period is usually 60 months (5 years). The recast principal balance cap (also known as the "neg am limit") is usually up to a 25% increase of the amortized loan balance over the original loan amount. States and lenders can offer products with lesser recast periods and principal balance caps; but cannot issue loans that exceed their state and federal legislated requirements under penalty of law.
A newer loan option has been introduced which allows for a 40-year loan term. This makes the minimum payment even lower than a comparable 30-year term.
All NegAM home loans eventually require full repayment of principal and interest according to the original term of the mortgage and note signed by the borrower. Most loans only allow NegAM to happen for no more than 5 years, and have terms to "Recast" (see below) the payment to a fully amortizing schedule if the borrower allows the principal balance to rise to a pre-specified amount.
This loan is written often in high cost areas, because the monthly mortgage payments will be lower than any other type of financing instrument.
Negative amortization loans can be high risk loans for inexperienced investors. These loans tend to be safer in a falling rate market and riskier in a rising rate market.
Start rates on negative amortization or minimum payment option loans can be as low as 1%. This is the payment rate, not the actual interest rate. The payment rate is used to calculate the minimum payment. Other minimum payment options include 1.95% or more.
NegAM loans today are mostly straight adjustable rate mortgages (ARMs), meaning that they are fixed for a certain period and adjust every time that period has elapsed; e.g., one month fixed, adjusting every month. The NegAm loan, like all adjustable rate mortgages, is tied to a specific financial index which is used to determine the interest rate based on the current index and the margin (the markup the lender charges). Most NegAm loans today are tied to the Monthly Treasury Average, in keeping with the monthly adjustments of this loan. There are also Hybrid ARM loans in which there is a period of fixed payments for months or years, followed by an increased change cycle, such as six months fixed, then monthly adjustable.
The graduated payment mortgage is a "fixed rate" NegAm loan, but since the payment increases over time, it has aspects of the ARM loan until amortizing payments are required.
The most notable differences between the traditional payment option ARM and the hybrid payment option ARM are in the start rate, also known as the "minimum payment" rate. On a Traditional Payment Option Arm, the minimum payment is based on a principal and interest calculation of 1% - 2.5% on average.
The start rate on a hybrid payment option ARM is higher, yet still extremely competitive payment wise.
On a hybrid payment option ARM, the minimum payment is derived using the "interest only" calculation of the start rate. The start rate on the hybrid payment option ARM typically is calculated by taking the fully indexed rate (actual note rate), then subtracting 3%, which will give you the start rate.
Example: 7.5% fully indexed rate − 3% = 4.5% (4.5% would be the start rate on a hybrid pay option ARM)
This guideline can vary among lenders.
Aliases the payment option ARM loans are known by:
Percentage rate of change in the NegAm payment. Each year, the minimum payment due rises. Most minimum payments today rise at 7.5%. Considering that raising a rate 1% on a mortgage at 5% is a 20% increase, the NegAm can grow quickly in a rising market. Typically after the 5th year, the loan is recast to an adjustable loan due in 25 years. This is for a 30 year loan term. Newer payment option loans often offer a 40 year term with a higher underlying interest rate.
The maximum interest rate allowed after recast according to the terms of the note. Generally most NegAm loans in the last 5 years have a life cap of 9.95%. Today many of these loans are capped at 12% or above.(In general Author is using time references that are relative to a time frame that is not defined. 'Today' which is?; 'last 5 years' from when, etc.)
The variable, such as the COFI; COSI; CODI or often MTA, which determines the adjustment as an increase or decrease in the interest rate. Other examples include the LIBOR and TREASURY.
Often disclosed in the adjustable rate rider of a Deed of Trust, the margin is determined by the lender and is used to calculate the interest rate. Often the loan originator can increase the margin when structuring the product for the borrower. An increase to the margin will also increase the borrower's interest rate, but will improve the yield spread premium which the loan originator may receive as compensation from the lender.
The fully indexed rate is the sum of the margin and the current index value at the time of adjustment. The F.I.R. is the "interest rate" and determines the interest only, 30 year and 15 year amortized payments. Most adjustable rate products have caps on rate adjustments. If the note provides for a single adjustment not to exceed an increase by more than 1.5, and the variable index, for example, increased by 2.5 since the last adjustment, the fully indexed rate will top out at a maximum adjustment of 1.5, as stated in the note, for that particular adjustment period. Often the F.I.R. is used to determine the debt to income ratio when qualifying a borrower for this loan product.
There are typically 4 payment options (listed from highest to lowest):
How often the NegAm payment changes. Typically, the minimum payment rises once every twelve months in these types of loans. Usually the rate of rise is 7.5%. The F.I.R. is subject to adjusting with the variable Index, most often on a monthly basis, depending on the product.
Premature stop of NegAm. Should the balance increase to a predetermined amount (from 110% up to 125% of the original balance per federal or state regulations) the loan will be "recast" with one of two payment options: the fully amortized principal and interest payment, or if the maximum balance has been reached before the fifth year, an interest only payment until the loan has matured to the recast date (typically 5 years).
End of NegAm payment schedule.
Negative-amortization loans, being relatively popular only in the last decade, have attracted a variety of criticisms:
In a very hot real estate market a buyer may use a negative-amortizing mortgage to purchase a property with the plan to sell the property at a higher price before the end of the "negam" period. Therefore, an informed investor could purchase several properties with minimal monthly obligations and make a great profit over a five-year plan in a rising real-estate market.
However, if the property values decrease, it is likely that the borrower will owe more on the property than it is worth, known colloquially in the mortgage industry as "being underwater". In this situation, the property owner may be faced with foreclosure or having to refinance with a very high loan-to-value ratio requiring additional monthly obligations, such as mortgage insurance, and higher rates and payments due to the adversity of a high loan-to-value ratio.
It is very easy for borrowers to ignore or misunderstand the complications of this product when being presented with minimal monthly obligations that could be from one half to one third what other, more predictable, mortgage products require.