Home Mortgage Loan Amortization and Negative Amortization

While shopping around for a mortgage, you probably do not know where to begin in deciphering all of your different mortgage options. As a supplement to our extensive Guide to Mortgage Loans, this article attempts to explain one of the most basic concepts of mortgages – amortization – along with its adversary, negative amortization.

Amortization

Amortization refers to the process of paying off a debt gradually through a series of installments rather than through a one-time payment. Mortgages generally are prime examples of this process. (Less often, it also is used interchangeably with “mortgage term” to describe the time period during which a mortgage will be repaid through regular monthly payments.)

Payments for an amortized loan encompass two different parts of one’s debt load: principal and interest. Principal debt is that which remains of the original loan that you borrowed, while interest debt is that which you owe in interest for use of the loan.

Your mortgage broker or lender can help you to determine the specific amortization schedule on your mortgage, which will specify the amount of your monthly payments that go toward paying capital and the amount that pays off interest. It also will tell you how much equity you can expect to have in your home at any given time.

In general, however, a large percentage of payments at the beginning of a mortgage term go toward interest and a smaller percentage to capital. The portion that goes to interest decreases gradually while the portion that goes to capital increases gradually as the loan ages.

Most mortgages, whether they are at a fixed rate or an adjustable rate, exemplify amortization.

Negative Amortization

Negative amortization is much rarer than amortization, but this backwards-sounding concept does exist. With negative amortization, the balance of one’s loan actually gradually gets larger as time as goes on.

This occurs when the monthly payments made on a mortgage are not enough to cover the accrued interest. This could happen in a couple of different ways.

For example, there are interest-only mortgages in which the monthly payments for the entire term of the loan go solely toward paying off interest. If a borrower reliably makes monthly payments under such a plan, then the balance due on the capital will neither increase nor decrease during the life of the loan. (The entire capital is due at the end of the mortgage term.)

If a borrower with an interest-only loan fails to make some minimum monthly payments, however, then the interest that remains unpaid will be added to the balance of the loan. The balance of the loan grows over time, and this is negative amortization.

Another example involves a type of mortgage called a payment-option adjustable-rate mortgage. Such mortgages allow borrowers to choose one of a few different payment choices on a month-to-month basis, and the minimum or “limited” option does not cover all interest due. This leads to negative amortization as well.

Conclusion

The choice between an amortized and a negative amortized loan may seem like a no-brainer, but in reality it depends on your financial situation. For example, if you unable to contribute very much to your monthly payments right now but are sure that you will be able to significantly increase your payments in the future, then negative amortization might just work for you. For those who can afford it, however, an amortized mortgage will save you money in the long run.