What is a negative amortization loan?
A negative amortization loan has a low monthly payment but accrues interest at a higher rate. Because the borrower is not paying enough to cover the interest accruing on the loan, it is added to the balance of the loan each month. Be cautious of loans advertised with very low rates such as 3.95% or 4.95%. Your initial payment will be calculated using this rate but the loan will generally accrue interest at the rate calculated by adding the current index to the loan margin. Add the index rate to the margin to determine the true cost of the loan. Often times a 3/1 or 5/1 ARM, or even a 30-year fixed, will give you a lower cost of borrowing. We would only recommend negative amortization to sophisticated individuals who are seasoned investors in a cash flow business.
In a negative amortization loan, your minimum monthly payments are lower than what you actually owe. As a result, the monthly payment is not enough to cover all of the interest due to the lender. The difference is added to the loan balance, and your balance will increase rather than decrease. These loans fill a special market need, and the borrower should be aware of the risks associated with them. When the interest rates are falling, this loan will work well for consumers who would not be able to afford their house otherwise. During rising interest rates they will face large payment increases.
