Negative Amortization and ARMs

Before completely delving into this topic, we should define amortization. Amortization is the process by which the principle of the loan is paid down, and occurs when monthly payments are large enough to pay the interest on the loan as well as a portion of the principle.

Negative amortization, on the other hand, occurs when the monthly payments on your loan do not completely cover the cost of interest. The unpaid interest gets added to the principle of the loan, and begins to generate even higher interest debts. If this continues to happen over a long period of time, you could end up owing significantly more than you did when your loan began.

This concept is particularly important in relation to ARMs that have a payment cap. The payment cap limits the amount of your monthly payments, so if your interest rate is adjusted upward substantially, you may find yourself in a negative amortization situation.

Negative amortization certainly sounds like a bad process, and one which should be avoided. At first glance, it seems you would be only spinning your wheels at best, and losing money at worst. However, if real estate values are appreciating at a decent rate, your equity gains will offset the bad effects of negative amortization.

In this case, the lower monthly payments assured by payment caps might be more attractive than working to reduce your principle. However, this is a decision only you can make. When considering an ARM with a payment cap, you should at least be aware of the possibility of a negative amortization situation and plan accordingly. The security of lower payments may be worth it for you, especially if you expect real estate values to increase over the long-term, but if you are uncomfortable with negative amortization you should consider finding an ARM with a periodic cap instead.