A negative amortization loan is any loan where the monthly payment does not cover the monthly interest expense. Interest-only or conventionally amortizing loans do not have this feature, and the monthly payments are based on the interest rate charged and/or the duration of the amortization schedule. Since the negative amortization loan breaks down this traditional relationship, there is a completely separate rate calculated for the minimum payment amount.
In general, this rate starts out low and increases gradually each year for the first several years. This is to allow the borrower time to adjust to a higher loan payment amount. These yearly increases are usually capped to prevent dramatic phenomenon known as “payment shock.”
The payment rate is based on an interest rate, but this rate has no relationship to the interest rate the borrower is being charged on the loan balance. The presence of two interest rates is responsible for much of the confusion regarding these loans.
The low starting payment rate is often called a “teaser rate” because it is a temporary inducement to take on the mortgage. There was a widespread belief among borrowers that one could simply refinance from one teaser rate to another forever in a process known as serial refinancing.
The negative amortization loan is one in which the full amount interest is not paid with each payment, and the unpaid interest gets added to the principal balance. Each month, the borrower is increasing the debt. These loans are inherently unstable, and most who used them ended up in foreclosure. This is the most toxic form of financing imaginable. The high default rates and extreme default losses caused this loan program to disappear.
Two of the features of all interest-only or negative amortization loans are an interest rate reset and a payment recast. All these loans have provisions where the interest rate changes or loan balance comes due either in the form of a balloon payment or an accelerated amortization schedule. In any case, borrowers often must refinance or face a major increase in their monthly loan payment. This increase in payment is what makes these loans such a problem.
The biggest confusion regarding this loan is when people mistake this payment rate for the actual interest rate they are being charged on the loan. This is a natural mistake to make because historic loan programs did not make this distinction. These loans were largely responsible for inflating the housing bubble, and the collapse of this financing method deflated it.
Lawrence Roberts is the author of The Great Housing Bubble: Why Did House Prices Fall?
Learn more and get FREE eBooks at: http://www.thegreathousingbubble.com/
Read the author’s daily dispatches at The Irvine Housing Blog: http://www.irvinehousingblog.com/
[tags]housing, real estate, buying real estate, housing bubble, real estate bubble, house for sale[/tags]
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