Negative Amortization Loan

A negative amortization loan refers to the financing option that allows a borrower to make a payment less than the standard installment set by the bank. The term negative in the term implies the decreased amount of scheduled payment that borrowers make, which ultimately leads to deferred interest instances.

An excess interest amount over the installment amount is added to the principal amount of the loan. It occurs because the borrower’s payments do not cover the total amount of interest accrued.

• A negative amortization loan is one where the borrower executes a payment lower than the bank’s minimum requirements. 
• It leads to business expansion, is useful for seasonal businesses, and helps students in higher education.
• This negative amortization loan option also has drawbacks, such as the principal amount increasing after some time due to the extra amount collating repeatedly.
• It is riskier than positive amortization as it compounds the principal amount and after a point, it gets more than the asset’s value.

A negative amortization loan is a type of finance in which borrowers choose to pay per their financial conditions. It is not required to make equal monthly payments per the standard amortization rate. Instead, lenders allow them to pay a lesser amount of interest. However, at the same time, the remaining interest amount gets added to the principal loan amount. The borrowers pay the total principal amount with interest at a later period.

It is a riskier option because the principal amount increases after every installment. Furthermore, the principal amount exceeds the value of assets after some time, and the borrower becomes liable to pay interest on interest.

Let us consider the negative amortization loan example to understand the concept well: Mr. X took a loan of $3,00,000 at 12% p.a. from the bank for ten years. Hence, he is liable to pay 60 monthly installments.

In the normal amortization schedule, Mr. X has to pay the equal monthly installment, which would reduce and the principal amount of the loan after each subsequent payment. 

Extract of 12 monthly installment repayment

However, in a negative amortization scenario, the bank offers Mr. X a chance to choose his payment option at his convenience. As a result, the borrower is free to pay less amount in every installment, facilitating an increase in the principal amount after the payment of each installment.

In the above example, if Mr. X has to pay only interest, it will be $3,000 every month. But in negative amortization, Mr. X can choose a lesser amount to pay, which increases the principal amount. As a result, Mr. X will be paying only $2,000 per month. Therefore, in the first month, there will be a short payment of $1,000, and the principal amount will increase by $1,000. In this manner, at the end of the 1st year, the principal balance will be $312,683.

Extract of 12 monthly installment repayment in negative amortization

This is how the negative amortization loan calculator works to calculate the outstanding dues.

Here are a few features that make negative amortization loans a savior for many borrowers:

#1 - Business Expansion

In the initial stage, business organizations opted for this scheme because they did not desire to make payments per the bank’s standard amortization installment. Instead, they chose to pay as per their comfort and use the extra money into capital expenditure for business expansion or pay higher installment at a later stage.

#2 - Help in Higher Studies of Students

Negatively amortizing loans helps students reduce the amount to be paid in their learning stage. After completing their education, they can make payments when they start earning. Thus, a student can pursue higher studies by facing less loan installment payment burden.

#3 - Useful for Seasonal Business

Some businesses do not operate for the whole year. Instead, they run only in specific seasons. This type of loan option is helpful because the borrower can make fewer payments during the off-season and make higher payments during the season.

Understanding the disadvantages helps make the meaning of negative amortization loans even clearer. Let us have a look at some of them:

#1 - Increase in Principal Amount

In negative amortization, the principal amount increases because the borrower makes lower interest payments than they need to pay, and this difference gets added to the principal amount. Therefore, gradually, the principal amount becomes more than the value of assets, and it is riskier if the borrower will not be able to make payments in the future.

#2 - Payment of Interest on Interest

In negative amortization, borrowers make minor interest payments than the interest accrued on the loan. Therefore, the remaining interest is added to the principal amount, and interest gets charged to this additional amount. It means the borrower has to make payments on subsequent interest amounts.

This has been a guide to what is Negative Amortization loan. Here we explain the concept with a calculation example along with the benefits, and drawbacks. You can learn more about finance from the following articles –

• Amortization Table
• Amortization of Bond Premium
• Prepare Amortization Schedule for a Mortgage
• Loan Amortization Schedule