Negative Amortization means that the loan balance can actually increase.
Negative amortization can acutually work for you if you are leveraging your money in the market. Make sure your broker knows your financial goals and background.
Negative amortization is when less than the interest accrued on the loan is being paid. Your loan balance will increase and eventually a higher loan amount must be paid off. Negative amortization is also called deferred interest.
Option ARMs (also known as pay option or pick-a-payment ARMs) function differently than other types of loan products. In general, the minimum payment will only change once a year. The interest only payment is calculated monthly.
If the interest only payment is greater than the minimum payment in any given month, you have the option to pay either amount. If you choose to pay only the minimum payment, any additional interest which is due is deferred at that time.
If you make the minimum payment the difference between the minimum payment and a principal and interest payment will be added back onto the balance of the mortgage.
When the loan is "re-cast", usually after five years, any deferred interest is then added to the principal balance resulting in Negative Amortization. The deferred interest can be paid at any time prior to the re-casting of the loan and becomes tax deductible once it has been paid.
The maximum amount of negative amortization that can occur is limited. Depending in which state your property is located, the limit is between 110% and 125% of the original principal balance.
Negative amortization can be a very bad thing if it continues to happen every single month. You will not build equity in your home, but you will actually lose equity in your home. Negative amortization type loans can be a good option for borrowers who have very unstable incomes where the ability to make an ultra low payment is available. This way when they are having a low income month they can simply make the lowest payment possible and when they have better income producing months they can make a much higher payment. Negative amortization loans are not for everyone.
Negative Amortization Option Arm loans can be an effective tool for those with investment properties who prefer a positive cash flow or for homeowners who receive large year end bonuses, etc. However, the option arm was not designed as a tool for the average consumer. The main questions to ask your mortgage professional are what the fully indexed rate of your proposed option arm is. This is the rate at which interest will accrue on your loan.
Negative Amortization, which is commonly referred to as deferred interest, is very similar to a home equity line of credit, except the minimum payment is generally much lower on the negative amortization loan. Beyond the potential tax deduction at sale or future refinance, the minimum payment option on these loans allows a borrower to make a very low minimum payment instead of the normal principal and interest payment, putting the difference in cash into their pockets each month.
For example, a $500,000 mortgage might have a full principal and interest payment of $3,000. A typical minimum payment option would be roughly half of this amount, $1,500. By selecting the minimum payment as necessary the difference, $3,000 - $1,500 = $1,500.00 which you are not paying is now "cash flow" in your pocket.
When interest is deferred, it is added to the loan balance, trading equity for cash! Because home equity is fundamentally illiquid, it has no real rate of return, and is generally inaccessible until a home is sold or refinanced again, at least under a conventional loan. When a loan offers a negative amortization, a borrower can choose to tap into their home equity to get cash on an ongoing basis, with no closing costs, and can choose when and how much to take out.
At the end of every year that you're on a Negative Amortization loan. You will receive a bill, with the accumulation of the deferred interest accrued through out that year. You will have two options, either pay it lump sum or add it to the loan amount (Principal loan is getting bigger).