Negative amortization loans, also known as deferred interest loans or payment option adjustable rate mortgages (ARMs), have gained popularity over the years due to their attractive initial payments. However, these types of loans can be risky and come with potential drawbacks that borrowers need to carefully consider before committing to them. In this article, we will discuss eight important points about negative amortization loans.
1. How Negative Amortization Loans Work:
Negative amortization occurs when the monthly payment made by the borrower is less than the interest accrued on the loan, resulting in unpaid interest being added back to the principal balance. As a result, the outstanding loan balance increases instead of decreasing over time.
2. Initial Low Payments:
One of the main selling points of negative amortization loans is their low initial payments. This feature makes them attractive for borrowers who are seeking affordable monthly payments in the short term.
3. Adjustable Interest Rates:
Negative amortization loans typically come with adjustable interest rates that can change periodically based on market conditions. This means that after an initial fixed-rate period, your interest rate may increase or decrease depending on prevailing economic factors.
4. Risky for Borrowers:
While low initial payments may seem appealing, negative amortization loans pose significant risks for borrowers in the long run. The increasing loan balance could lead to higher future mortgage payments or even difficulty in repaying the debt if property values decline or income circumstances change.
5. Potential Negative Equity:
Negative equity refers to owing more on your home than its current market value—a situation commonly associated with negative amortization loans due to their increasing balances and fluctuating property values.
6. Limited Timeframe Options:
Most negative amortization loans offer a limited time frame during which you can make minimum payments only before transitioning into fully-amortizing payments at a later date (typically 5 years). Once this transition happens, your monthly payment will significantly increase since you’ll need to start paying down both principal and interest.
7. Financial Discipline Required:
To avoid the potential pitfalls of negative amortization loans, borrowers must exercise financial discipline and make higher payments than the minimum required whenever possible. This can help reduce the risk of unpaid interest accumulating and causing a significant increase in monthly payments when the loan transitions to its fully-amortizing phase.
8. Alternative Options:
Considering the risks involved, it is essential to explore alternative financing options before committing to a negative amortization loan. Traditional fixed-rate mortgages or adjustable rate mortgages without negative amortization features might provide more stability and predictability for borrowers.
In conclusion, while negative amortization loans may seem appealing initially due to their low initial payments, they come with significant risks that borrowers should carefully consider. The potential for increasing loan balances, fluctuating property values, and higher future mortgage payments make these types of loans risky choices for many individuals. It’s crucial to thoroughly assess your financial situation and explore other alternatives before deciding on a negative amortization loan. Consulting with a reputable mortgage professional can also provide valuable insights into what option suits your needs best if you’re considering this type of financing.