Negative Amortization

With the development of alternative mortgage instruments (AMIs), it is possible (in some cases, required) to have negative amortization, or the increasing of the outstanding balance of the mortgage after making debt service payments. For example, whenever the debt service payment is less than the interest owed for the period, the failure to cover the interest obligation results not only in a zero principal payment but also, in fact, adds to the outstanding balance of the mortgage. This negative amortization has important implications for lenders, borrowers, housing markets, and the choice of mortgage instruments. It is important to note that negative amortization differs from failing to make mortgage payments. Negative amortization is built in by design to some mortgages; failing to keep current in repayment of the mortgage debt can lead to default and foreclosure.

During the financial crisis of 2007 to 2009, there was a new round of negatively amortized mortgages. Under option-adjustable rate mortgages (ARMs), a complicated and aggressive mortgage used in sub-prime markets, borrowers could choose to pay less than the amount needed to cover the interest. If they did so, the unpaid interest was added to the outstanding principal. During this period, borrowers expected to sell the property in the months ahead at inflated prices or refinance to get equity out of the property; in either case, adding additional amounts to the outstanding balance due to negative amortization was not taken seriously. This proved to be very costly for most borrowers using option-ARMs, especially since property values began to fall and sales or refinancing were no longer a strategic option.

Traditionally, a fixed-rate mortgage (FRM) would be amortized over a long period of time. Each debt service payment would be used to reduce the outstanding balance of the mortgage loan. First, the interest would be deducted from the debt service payment, and any additional funds would be used to pay off (amortize) the loan. (This amortization payment is sometimes called the sinking-fund payment.) The FRM payment is calculated so as to include the precise amount for the sinking-fund payment (although it increases with each payment) so as to completely repay the loan at the end of its life and at a constant interest rate.

If the minimum FRM payment is made, there can only be positive amortization. If additional money is paid on the mortgage in addition to the minimum FRM payment, there is accelerated amortization (i.e., each additional dollar is applied to the outstanding balance as a prepayment thus accelerating the repayment schedule). However, if less than the minimum FRM payment is made, a negative amortization occurs (plus there may be penalties) since the outstanding balance owed has grown from the previous period.

Certain instruments promise negative amortization by design; others permit negative amortization under certain conditions. For example, the use of the graduated-payment mortgage (GPM) requires that negative amortization occur for a fixed period of time. For an adjustable-rate mortgage (ARM), negative amortization can take place under some conditions. During the 2000s, there were many variations of the basic mortgage design regarding amortizations.

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