Question: What is "negative amortization?"

Answer: We usually think of mortgages as debts that are paid off over time. This happens because monthly payments cover interest costs and a reduction of principal. Loans that are re-paid over their terms are called "amortizing" or "self-amortizing."

With some ARMs, however, we can have a situation where monthly payment increases are limited. At the same time, it is possible for interest rates to rise enough so that monthly payments do not cover monthly interest costs. Example, the monthly payment is $500 but the monthly interest cost is $525.

With most loans, if there is no allowance for negative amortization, the loan becomes an interest-only mortgage for a time -- $500 a month in payments and $500 a month in interest. If this situation continues until the end of the loan, then a large final payment will be due (maybe thousands of dollars, or tens of thousands of dollars).

But, some loans permit negative amortization. In this case, the monthly payment would be $500, the interest cost would be $525, $500 in interest would be paid off with the monthly payment, and $25 would be added to the mortgage debt. Increasing the size of the loan balance is called "negative amortization." If the loan term ends without amortization, the remaining debt could be larger than the original mortgage amount.

Negative amortization can generally be off-set by increasing monthly payments. Also, loan papers typically limit the amount of negative amortization to 125 percent of the original loan amount.

Borrowers are advised to carefully review all terms associated with any loan program. When negative amortization is permitted, borrowers should understand that such a clause potentially allows lenders to collect interest that may not be collectible under other loan programs. Alternatively, negative amortization loans may offer other terms which borrowers may find enticing.