The Consumer Financial Protection Bureau says: “Amortization means paying off a loan with regular payments, so that the amount you owe goes down with each payment. Negative amortization means that even when you pay, the amount you owe will still go up because you are not paying enough to cover the interest.”
How It Happens
Some borrowers experience negative amortization with an adjustable-rate mortgage (ARM). An ARM is a home loan with an interest rate that fluctuates based on consumer indexes. In order to protect borrowers from steep increases, some ARMs include a cap on your monthly payment. However, if rates rise enough, that maximum payment may not be enough to cover your monthly interest. When that happens, the unpaid interest is added to your principal, effectively increasing your loan balance rather than paying it down. This can lead to more issues for a borrower. If the housing market in your area experiences a downturn and your home value declines while your loan principal continues to increase, you may find yourself with an upside-down mortgage and that means you owe more money than the worth of your home.
Avoiding Negative Amortization
The first step to avoiding negative amortization is to confirm with your mortgage provider the type of mortgage that you currently have to determine your risk of having to deal with this scenario. The simplest way to prevent negative amortization is by always ensuring your monthly payments cover the interest accrued. This could mean paying more than your minimum monthly payment. Another option is to refinance with a fixed-rate mortgage.
Source: https://openmortgage.com/negative-amortization-what-it-is-and-how-to-avoid-it
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