Legal Definitions - negative amortization

Negative amortization occurs when the principal balance of a loan increases over time, even while the borrower is making payments. This happens because the regular payments being made are not large enough to cover all the interest that accrues during that payment period. The unpaid portion of the interest is then added to the loan's original principal amount, causing the total debt to grow larger.

This arrangement is sometimes used in specific financial situations, such as certain types of specialized loans or as part of a bankruptcy reorganization plan, where a borrower might have lower income initially but expects higher income or asset sales in the future.

• Example 1: Business Bankruptcy Reorganization

  A manufacturing company, struggling through a temporary downturn, files for bankruptcy and proposes a reorganization plan to its creditors. As part of this plan, the company negotiates with its primary bank to pay only a portion of the interest due on its secured business loan for the first two years. The remaining unpaid interest is not forgiven but is instead added to the principal balance of the loan. The company expects to return to profitability after two years and will then begin making full payments on the now larger principal amount.

  This illustrates negative amortization because the loan's principal balance grows during the initial two-year period, even though the company is making partial interest payments. The deferred, unpaid interest is capitalized, meaning it's added to the original debt, increasing the total amount owed.

• Example 2: Specialized Mortgage Product

  Many years ago, some homeowners took out a type of adjustable-rate mortgage (ARM) known as an "option ARM." This loan allowed borrowers to choose from several payment options each month, including a minimum payment that could be less than the interest actually due. For instance, if a homeowner's interest due for a month was $1,800, but they chose to make a minimum payment of only $1,200, the unpaid $600 of interest was added to the loan's principal balance. Over time, if the homeowner consistently made these minimum payments, they could end up owing more than the original amount they borrowed.

  This demonstrates negative amortization because the monthly payments were insufficient to cover the accruing interest. The shortfall was added to the loan's principal, causing the outstanding debt to increase rather than decrease, even while the homeowner was making regular payments.