Negative amortization

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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. 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.


Defining characteristics[edit]


Neg-Ams also have what is called a recast period, and the recast principal balance cap is 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.


Typical circumstances[edit]





Adjustable rate feature[edit]



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:

  • Negative Amortizing Loan (Neg Am)
  • Pick - A - Pay
  • Deferred interest option loan (this is the way this loan was introduced to the mortgage industry when first created)

NegAm - mortgage terminology[edit]

  • Cap
  • Life cap
  • Index
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.
  • Margin
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.
  • Fully indexed rate (F.I.R.)
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.
  • Payment options
There are typically 4 payment options (listed from highest to lowest):
  • 15 year payment
      • Amortized over a period of 15 years at the F.I.R.
    • 30 year payment
      • Amortized over a period of 30 years at the F.I.R.
    • Interest only payment
      • F.I.R. times the principal balance, divided by 12 months (with no amortization or reduction in the owed balance).
    • Minimum payment
      • Based on the minimal start rate determined by the lender. When paying the minimum payment, the difference between the interest only payment and the minimum payment is deferred to the balance of the loan increasing what is owed on the mortgage.
  • Period
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.
  • Recast
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).
  • Stop
End of NegAm payment schedule.

Negative amortization loans[edit]


In a reverse mortgage borrowers do not need to make payments on their loan until it is due. A reverse mortgage is due only when the borrower no longer resides in his or her principal residence.[1]


Negative-amortization loans, being relatively popular only in the last decade, have attracted a variety of criticisms:

  • Unlike most other adjustable-rate loans, many negative-amortization loans have been advertised with either teaser or artificial, introductory interest rates or with the minimum loan payment expressed as a percentage of the loan amount. For example, a negative-amortization loan is often advertised as featuring "1% interest", or by prominently displaying a 1% number without explaining the F.I.R. This practice has been done by large corporate lenders. This practice has been considered deceptive for two different reasons: most mortgages do not feature teaser rates, so consumers do not look out for them; and, many consumers aren't aware of the negative amortization side effect of only paying 1% of the loan amount per year. In addition, most negative amortization loans contain a clause saying that the payment may not increase more than 7.5% each year, except if the 5-year period is over or if the balance has grown by 15%. Critics say this clause is only there to deceive borrowers into thinking the payment could only jump a small amount, whereas in fact the other two conditions are more likely to occur.
  • Negative-amortization loans as a class have the highest potential for what is known as payment shock. Payment shock is when the required monthly payment jumps from one month to the next, potentially becoming unaffordable. To compare various mortgages' payment-shock potential (note that the items here do not include escrow payments for insurance and taxes, which can cause changes in the payment amount):
    • A 10-year interest only mortgage product, recasting to a 20-year amortization schedule (after ten years of interest-only payments) could see a payment increase of up to $600 on a balance of 330K.
    • Negative amortization mortgage: no payment jump either until 5 years OR the balance grows 15% (depending on the product) higher than the original amount. The payment increases, by requiring a full interest-plus-principal payment. The payment could further increase due to interest-rate changes. However, all things being equal, the fully amortized payment is almost triple the negatively amortized payment.
    • First month free: a loan officer may allow the borrower to skip the first monthly payment on a refinance loan, by simply adding that payment to the principal and charging compound interest on it for many years. The borrower may not understand or question the transaction.

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, if the property owner cannot make the new monthly payment, he or she 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.

Difference between negative amortization and a reverse mortgage[edit]

A negative amortization mortgage should not be confused with a reverse mortgage. A negative amortization mortgage is a mortgage where the principal increases throughout the early stage of the mortgage. This early stage is known as the negative amortization or NegAm period. During this time period the borrower is, in effect, making partial payments toward his mortgage. The remainder of his payment, which he is not paying, is added onto the amount owed on the mortgage. Naturally, when this period ends, he must start to pay this additional amount off, along with his original principal.

A reverse mortgage happens when a homeowner, usually a retired person, sells some or all of his equity in his home and retains the right to live there. No payments are due until the homeowner sells the house, moves out of the house, or dies. However, all the interest charged on the loan is applied back to the principal, since no interest payments are made during the life of the loan.


See also[edit]