Negative Amortization: The Risk of Adjustable Rate Loans
Negative Amortization is when the balance of a loan increases instead of decreases. Usually due to a borrower making a minimum payment on an Adjustable Rate Mortgage during a period when the rate fluctuates to a high enough point that the minimum payment does not cover all of the interest. This is one of the biggest risks of interest-only loans with payment options for borrowers that fail to pay any amount to the principal over the course of their loan.
If your property is in an area that is appreciating rapidly, this may not seem like a reason for concern. However, since markets are always changing, it is impossible to be certain that you can be assured of an increase in equity based on appreciated value alone.
If you make minimum payments and they don’t cover each month’s interest, that will be tacked on to the principal balance. Over time that can mean a significant increase in your loan amount. If property values don’t keep up or worse decline, you may find you owe more than you originally paid or more than you can sell it for at current market value.
Be very sure that you thoroughly understand the risk of negative amortization anytime you are considering an adjustable rate mortgage. While loans programs offer multiple options both in terms and payments, you should always base your decision on worst-case scenario. If you opt for an interest-0nly loan, make some payment to your principal balance on a regular basis and you will be much less likely to experience negative amortization on your mortgage.