When a scheduled payment is less than the interest due, the difference is added to the principal amount as deferred interest.

Deferred interest accrue and causes the principal loan balance to increase, the event is known as negative amortization.

These occurrences are common in interest-only ARMs.

For example, an interest-only ARM is still in it’s interest-only period and has a monthly repayment of $500. Because a volatile interbank rate is causing monthly payment to swing, the next payment due becomes $550. By continuing to only pay $500, the difference of $50 will be added to the principal amount.

While a lender might allow negative amortization to occur on a loan, they usually have limits set on them.

Upon hitting these limits, the lender might recast the mortgage, resulting a higher monthly payment amount.