Imagine that you’re applying for a mortgage and you have the option of choosing a payment plan. If you want to be debt-free, you might opt for a plan that covers the principal balance and any interest that you owe. On the other hand, if money is tight, you might decide to make the smallest possible payment toward your interest amount.
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Amortization: The Basics
If you’ve taken out a loan for a house or a car, you’ve probably come across an amortization schedule. In layman’s terms, amortization is simply the process of paying off debt over a period of time. And with most debts, you’ll have to pay your lender back the principal and interest.
Your loan principal is the total amount of money that you borrow. Once you start making payments, the term principal also refers to how many hundreds or thousands of dollars you still owe. That number doesn’t include interest, which is the extra money you pay your lender for the privilege of borrowing.
An amortization schedule gives you a breakdown of what you should pay each month in order to pay off your loan in full. For example, if you take out a $200,000 mortgage, your amortization schedule will show your beginning principal amount ($200,000), how much you’re expected to pay toward your principal and your interest and how much you’ll have left over if you make those payments on time.
Making minimum payments on your mortgage might work well for a while. But you might not be too pleased with yourself in the future if you have to deal with something called negative amortization.
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How Negative Amortization Works
As you send in checks to pay off your debt, you might think it’s safe to assume that your principal balance is going down month by month. In your mind, you may be picturing that huge $200,000 amount gradually dropping to $150,000 and $130,000 and so on.
What if your principal owed in fact grows, $200,000 to $250,000? That means that you’re dealing with negative amortization.
A closer look at your amortization schedule might reveal that the majority of your money seems to be going toward interest, especially if you’re not very far into your loan term. That’s normal. Eventually, your lender will apply more and more of your payments to your principal balance.
Hypothetically speaking, you may be scheduled to pay $550 for your first loan payment, with $420 going toward interest and $130 covering your principal amount. If funds in your household are running low and you pick a payment plan that lets you only pay $150, the remaining interest amount might be added to your principal. And that’s how you end up with more debt than you had originally.
So negative amortization happens whenever your principal goes up as a result of not paying all of your interest.
Related Article: What Is an Amortizing Loan?
Negative Amortization Mortgage Loans
Some mortgages fall into the category of negative amortization loans. Graduated payment mortgages initially come with low payments that get more expensive year after year until you’re paying interest at a higher fixed rate. Payment-option adjustable-rate mortgages let you choose the payment plan that works best for you, whether that’s paying the principal and the interest or just the interest by itself.
Negative amortization mortgage loans generally give you the opportunity to make small contributions below the suggested interest and principal payment amounts. This feature might be helpful for first-time homebuyers, people looking to stay in their home temporarily and others who don’t have enough money socked away to keep up with the amortization schedules created for their mortgages. It also allows people to buy homes that they want but can’t afford, believing they’ll be able to pay for them when they have higher salaries.
Those lower monthly payments can turn into a major migraine, however, if your unpaid loan amount gets so big that your term is extended and you’re faced with an unbearable amount of new interest piled on top of old interest. You’re then putting yourself at risk of foreclosure and jeopardizing your credit score if you can’t pay your lender back.
With most loans, you reduce your outstanding principal balance as time goes on. Yet with negative amortization loans, you ultimately owe your lender more money than you borrowed in the first place. While you might be able to settle for lower payments in the short-term, you may be shocked by the amount that comes due in the long run.
Taking the time to read your loan terms carefully is one of the most important things you can do as a borrower. That way you’re aware of your lender’s expectations and you can prepare yourself to make those higher mortgage payments years down the line.
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