What it means
In a normal loan, each payment covers the interest for the period and also repays a slice of the original amount borrowed, which is called the principal. The balance falls over time until it reaches zero.
In a negatively amortising loan, the payment does not even cover the interest, and the shortfall is added to the balance. Lenders offer these structures for borrowers who expect their income to rise or who want low early payments.
Examples include certain option adjustable-rate mortgages, some graduated-payment loans, and some development or bridge loans where cash flow starts slowly. The borrower gains breathing space in the early years.
The danger is that the debt compounds. Next month's interest is calculated on the larger balance, so the shortfall grows, and the borrower can end up owing more than the property or business is worth.
Most agreements include a cap, often expressed as a percentage of the original loan, that forces the payments to be reset once the balance reaches the cap. When that reset arrives, payments can jump sharply because the larger balance now has to be repaid over the remaining term.
This payment shock has caught many borrowers out, so a finance team needs to model the future schedule and not just the starting payment. Business borrowers should also check what happens to their covenants when the balance rises.
The key nuance is that negative amortisation is not automatically bad. Used with care for a project that will soon produce strong cash flow, or for a short bridge, it can be a sensible tool.
Used by someone whose income is flat, it can be a trap.
In practice
Real-world examples.
Example
A first-time home buyer takes a mortgage with a low starting payment because she expects her salary to double within three years. For the first two years, her payment is $300 a month below the interest due. Her lender explains that her balance will have grown by about $7,000 when the payments reset.
Example
A property developer borrows $5,000,000 to build apartments, with payments set below the interest while construction is under way. The unpaid interest is added to the loan. Once the apartments are let, the developer refinances into a standard loan.
Example
A small manufacturer takes a seasonal loan with low payments in the quiet months and higher payments in the busy season. During the quiet months the balance rises slightly. The owner tracks the balance monthly to make sure it falls back by year end.
Formula
Calculation
Interest for the period = opening balance x annual rate / 12
New balance = opening balance + interest - payment
A borrower takes a $200,000 loan at 6% a year with a monthly payment of $700. Month 1 interest = 200,000 x 0.06 / 12 = $1,000. The payment falls short by 1,000 - 700 = $300, so the new balance is 200,000 + 300 = $200,300. In month 2, interest = 200,300 x 0.06 / 12 = $1,001.50, so the shortfall is $301.50 and the balance rises to $200,601.50.Case study
Seen in the real world.
Maple Ridge Homes is a fictional builder that offered buyers a loan with a very low starting payment. Many of the buyers in this illustrative story accepted the offer because it made the monthly cost look similar to renting. Each month, however, a few hundred dollars of unpaid interest were added to their balances.
After five years, house prices were flat and balances had risen by almost 10%, so several buyers owed more than their homes were worth. When the payments reset, bills rose by 40%. The company's finance team learned that selling on the basis of the starting payment alone had created heavy complaints, and it changed its disclosure to show the payment after the reset.
Watch out
Common mistakes.
- Looking only at the starting payment. The payment after the reset can be much higher, so the full schedule must be reviewed before signing.
- Assuming the balance will fall automatically over time. In this loan type the balance can rise for years, and it falls only after the payment exceeds the interest.
- Believing a rising home price will always rescue the borrower. Prices can stall or fall, leaving the borrower owing more than the asset is worth.
Questions
People also ask.
Is a negatively amortising loan the same as an interest-only loan?
No, because an interest-only loan covers the interest and leaves the balance flat, while this type leaves part of the interest unpaid and increases the balance.
What is a recast?
A recast is the point at which the lender recalculates the payment so the loan will be repaid in full over the remaining term, usually causing a higher payment.
Who might benefit from such a loan?
Borrowers with temporarily low cash flow but strong expected future income, such as developers or early-career professionals, may benefit if they plan the exit carefully.
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