Negative Amortization (Deferred Interest)

What is negative amortization?
Negative amortization, or "deferred interest," describes loans that have payment adjustment caps in addition to interest rate adjustment caps. What does this mean? Simply put, while your payment may stay the same, the loan's interest might increase.

If the interest rate rises, and you choose not to pay off any of the principal, the overall loan amount will increase. This gives it the label "negative amortization." Most loans do not have a negative amortization feature, and are designed to reduce to a zero balance by the end of their terms.

How does negative amortization occur?
Negative amortization loans calculate two interest rates. The first is called the payment rate, which is shown in blue below; the second is the actual interest rate, which is shown in red. The payment rate is typically capped at 7.5% of the previous payment. Meanwhile, the true interest rate is calculated as the index plus the margin without periodic caps. This can lead to a cycle of growing interest without paying down the principal-causing you to owe more rather than less.

Borrowers are often given a choice of which rate to pay. Advertisers of negative amortization loans usually refer to them as "payment option" loans. However, while it is true that you have a payment option, which offers flexibility, you will still be subject to the true interest rate.

Risk Considerations
In exchange for lower payments, those of you with a negative amortization loan assume more speculation. The risk rests in the interest you pay, which does not have a monthly rate cap and can increase to the lifetime cap at any time. This is fundamentally different from "no negs," which always have periodic caps.

Therefore, in terms of building equity in your home, negative amortization loans can trap you in a cycle of paying only the constantly growing interest, completely neglecting the principal.

When to Consider a Negative Amortization Loan
Negative amortization loans can be useful if you are primarily concerned with cash flow instead of building equity. If you only pay the payment rate, the overall monthly mortgage payment might be much lower than a typical 30-year, "no neg" amortization loan. Given this, negative amortization loans may be a temporary solution if income is reduced for a period of time, or if the hold period is short term to minimize cash outflow.

Nevertheless, one of the main reasons for purchasing a home is to build equity and generate greater wealth. If you are primarily concerned with cash flow, a better strategy may be to simply rent rather than own.