What it means
Normally, when you borrow money and make a repayment, part of that payment covers the interest for the period, and the remainder pays down the actual loan amount, known as the principal. With negative amortisation, your monthly payment is set lower than the interest that accumulates.
This often happens with certain types of mortgages or flexible business loans designed to keep initial payments artificially low. While it gives you immediate breathing room on your cash flow, it comes with a hidden cost.
Because the unpaid interest rolls over into the principal, you end up paying interest on top of interest. Over time, this creates a snowball effect where your overall debt increases even though you are making regular payments.
Eventually, the loan terms will force a recalculation, leading to a sharp payment shock when you are required to pay off the much larger balance. Imagine riding a stationary exercise bike where the resistance automatically increases faster than you pedal.
Even though you are moving your legs, you are actually losing ground and slipping backwards.
In practice
Real-world examples
Example 1
A startup founder takes a flexible $100,000 business loan at 6% with payments of $300 a month, below the $500 of monthly interest. Each month the unpaid interest is added to the balance. After a year the loan has grown to roughly $102,500 even though every payment was made on time.
Example 2
A retail SME uses a special financing package with low introductory instalments of $200 a month on a $50,000 loan at 8%. The monthly interest is about $333, so the balance keeps rising. After 24 months of negative amortisation, the debt has grown to roughly $53,500, raising future costs.
Example 3
A commercial property investor buys a warehouse with a $200,000 deferred interest facility at 6%. Payments of $800 a month fail to cover the $1,000 of monthly interest. After 24 months the loan balance has crept up to about $205,100, and the investor owes more than at the start.
Think of it
Imagine riding a stationary exercise bike where the resistance automatically increases faster than you pedal. Even though you are moving your legs, you are actually losing ground and slipping backwards.
Formula
Calculation
Ending Balance = Beginning Balance + Interest Charged - Payment Made
Worked example: you owe $100,000 at 6% annual interest, so the monthly interest is $100,000 x 6% / 12 = $500. If your payment is only $300, the shortfall of $200 is added to the loan: $100,000 + $500 - $300 = $100,200.
The next month, interest is charged on the larger balance: $100,200 x 6% / 12 = $501. With the same $300 payment the balance becomes $100,200 + $501 - $300 = $100,401. Each month the gap widens slightly, which is how interest on interest builds up. After 12 such months, the balance would be about $102,467, so $2,467 of interest has been added to the debt even though every payment was made on time. Compare this with an ordinary loan, where each payment is larger than the interest and the balance falls.Case study
Seen in the real world
This is a fictional, illustrative scenario. GreenLeaf Logistics, a mid-sized delivery firm, needed new vans to expand operations. To preserve short-term cash flow during a slow season, the directors opted for a specialist vehicle loan that offered low introductory payments featuring negative amortisation. For the first eighteen months, their monthly payments were fixed at $400, while the interest accumulating on the $80,000 loan at 9% was about $600 each month.
The roughly $200 difference was added directly to their loan principal every month. After eighteen months, the total debt had grown from $80,000 to about $83,800. At this point, the loan agreement triggered a mandatory recalculation, resetting the monthly payments to amortise the newly inflated balance over the remaining seven years. GreenLeaf suddenly faced monthly payments of about $1,350 instead of the expected $400.
The sudden jump strained their operating budget, forcing them to delay office upgrades and tighten expenses to avoid defaulting on the restructured debt. Looking back, the directors realised the cash relief in the slow season was really a loan from their future selves. Their payments had covered only two thirds of the interest, and they ended up owing about $3,800 more than they borrowed. The lesson was to ask lenders for the date and size of the first recalculation before signing, not after, and to build the higher payment into the cash flow forecast from day one.
Watch out
Common mistakes
- Assuming that making every scheduled payment means you are successfully paying off your debt.
- Ignoring the loan contract details regarding the date when payments will automatically reset to a higher amount.
- Failing to calculate the long-term total cost of the borrowing, focusing only on the short-term cash flow relief.
Questions
People also ask
Why would anyone choose a loan with negative amortisation?
It provides short-term cash flow relief for businesses or individuals who expect their income to rise significantly in the future.
Is negative amortisation legal?
Yes, but lenders are heavily regulated and must clearly disclose the risks and the point at which payments will increase.
What is a recast?
A recast is when the lender recalculates your monthly payments to ensure the loan is fully paid off by the end of its original term, usually causing payments to jump.