Negative amortization is a financial term that refers to an increase in the principal balance of a loan caused by a failure to cover the interest due on that loan. In other words, negative amortization occurs when the loan payment for any period is less than the interest charged over that period, so the outstanding balance of the loan increases. Here are some key points to understand about negative amortization:

• Amortization: Amortization refers to the process of paying off a debt (often from a loan or mortgage) through regular payments. A portion of each payment is for interest while the remaining amount is applied towards the principal balance. The percentage of interest versus principal in each payment is determined in an amortization schedule.

• Negative Amortization: Negative amortization only occurs in loans in which the periodic payment does not cover the amount of interest due for that loan period. The unpaid accrued interest is then capitalized monthly into the outstanding principal balance. The result of this is that the loan balance (or principal) increases by the amount of the unpaid interest on a monthly basis.

• Risks: A negative amortization loan can be risky because the borrower can end up owing more on the loan than the asset is worth. This can make it harder to sell the asset because the sales price won’t be enough to pay what is owed, putting the borrower at risk of foreclosure if they run into trouble making their payments.

• Examples: Negative amortization is common among certain types of mortgage products, such as payment option adjustable-rate mortgages (ARMs), which let borrowers determine how much of the interest portion of each monthly payment they elect to pay. Any portion of interest that they opt not to pay is then added to the principal balance of the mortgage.

To avoid negative amortization, borrowers should confirm with their mortgage servicer the type of mortgage they have to determine their risk of encountering the situation. The simplest way to avoid negative amortization is to make payments that cover the interest due and some of the principal balance.