Negative Amortization
Negative amortization summary:
Negative amortization is when the principal balance of a loan increases.
Negative amortization occurs when the payments made on a loan are less than the interest charged for a given period.
If you don’t cover at least the interest costs, interest will capitalize. That means the unpaid interest is added to the balance that you owe, and then you’re charged interest on the new, higher amount. Negative amortization increases borrowing costs.
Negative amortization definition and meaning
Negative amortization occurs when the principal balance of a loan increases. This could happen when a borrower doesn't make payments, or doesn’t pay enough to cover interest charges. Negative amortization is common on deferred loans. A deferment is a temporary payment pause.
If you don’t make interest-only payments during the deferment period, but the lender continues to charge interest, that interest will capitalize. That means the unpaid interest is added to the balance that you owe. The next month, interest is charged on the new, higher amount.
Key concept: Negative amortization is an increase in a loan's principal balance, which occurs when a borrower's monthly payment isn't enough to cover the interest charges.
More about negative amortization
Negative amortization happens when a loan payment is less than the interest charged during that time. This results in a higher loan balance .
In contrast, amortization is the process of gradually reducing your debt by making payments over time. Usually, the principal balance of a loan goes down at least a little bit with each payment. But that’s not the case if you miss payments or make payments that are less than the interest costs.
It’s possible to skip payments on some loans. For example, on federal student loans, you might be allowed to pay nothing at all while you’re in school full-time. Federal student loans are either subsidized or unsubsidized. On subsidized loans, the government pays the interest for you while you’re in school. On unsubsidized loans, no one pays the interest for you. If you don’t pay it yourself, your balance will grow.
You can avoid negative amortization by making payments that are at least big enough to cover the interest charges on your loan.
Negative amortization is almost never a good idea for everyday borrowers because it raises the overall cost of borrowing.
Negative Amortization FAQs
How does deferment or forbearance affect loan cost?
Deferment and forbearance allow you to temporarily pause loan payments. If interest continues to accrue while your loans are deferred or in forbearance and you don't make any payments toward the interest or principal during this time, that could leave you with a larger loan balance to repay.
What happens when a loan has negative amortization?
If you make a payment that’s not enough to cover the interest charges on your loan, the interest will be added to the amount you owe. That’s negative amortization. It makes a loan more expensive.
How can I avoid negative amortization?
You can largely avoid negative amortization by making payments that are at least enough to cover interest charges. If the lender doesn’t charge other fees that get added to your balance, the amount you owe won’t go up. Interest-only payments are a good strategy during a period of non-payment, such as student loan deferment.
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