When interest is due and not fully paid for, it is added to the outstanding balance of the loan.
This is generally referred to a accrued interest. But in the world of mortgages, it is professionally referred to as negative amortization.
This unusual but not uncommon scenario can occur in various ways.
One of which is the borrower paying a fixed monthly installment on a loan. But when interest rates rise, which can occur with an adjustable rate mortgage (ARM), the required payment is more than the installment amount.
Since the monthly loan payment is insufficient to completely cover the accrued interest, the unpaid interest makes it’s way into the principal balance.
The result is a rise in amount owing rather than a drop. Thus, negative amortization.
For example, if a homeowner repays $500 each month towards the home loan and the repayment rises to $550, the difference of $50 will be added to the loan as accrued interest or deferred interest.
Whether the borrower is obligated to make full payments on the new monthly installment depends on the terms of contract.
However, even if the borrower is not required to make full monthly payment, the accumulated balance will still have to be settled to close the loan in order to take over possession of the title from the lender.
With a view of unpredictable and irregular interest rate movements and hikes, lenders often include a negative amortization cap on mortgages to assure borrowers that the amount they owe will never increase to outrageous heights.
This will give borrowers more peace of mind in signing up.
For example, the negative amortization cap might be set at 110% of the original loan amount.
Meaning no matter how high interest rates might rise, the maximum the borrower’s outstanding amount can accumulate is up to 110% of the original loan.