Negative Amortization Definition
Negative Amortization refers to a situation when the borrower make the payment that is less than the standard installment which is set by the bank and therefore, the excess of interest amount over the installment amount is added to the principal amount of loan. This occurs because the borrower’s payments don’t cover the total amount of interest that has accrued.
Example of Negative Amortization
Mr. X has taken a loan of $ 3,00,000 at 12% p.a. from Bank for 10 years i.e., and it will be paid in 60 monthly installments.
In the normal amortization schedule, Mr. X has to pay the equal monthly installment and by which the principal amount of the loan will reduce after every payment of installments.
Extract of 12 monthly installment repayment
However, in a negative amortization scenario, the bank offers Mr. X to “Choose your Payment” option, in which the borrower can make less payment in every installment as per his capacity. In this case, the principal amount of the loanPrincipal Amount Of The LoanLoan Principal Amount refers to the amount of money loaned by the lender to the borrower. Furthermore, it is the amount on which the lender charges the borrower interest for fund utilization. will increase after the payment of every installment.
In the above example, if Mr. X has to pay only interest, then he has to pay $ 3,000 every month, but in negative amortization, Mr. X can choose lesser payment, but this leads to an increase in the principal amount. Mr. X is only paying $ 2,000 per month; therefore, in the first month, there is short paid of $ 1,000, and the principal amount will increase by $1,000 and, in this manner, at the end of the 1st year principal balance will be $ 3,12,683.
Extract of 12 monthly installment repayment in negative amortization
Benefits of Negative Amortization
#1 – Business Expansion
In the initial stage, business organizations are opting for this scheme because, in this scheme, they need not require to make payment as per bank standard amortization installment they can choose to make payment as per their comfort level and use the extra money into capital expenditureCapital ExpenditureCapex or Capital Expenditure is the expense of the company's total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year. for expansion of business and make the payment of higher installment at a later stage.
#2 – Help in Higher Studies of Students
Negatively amortizing loans are useful for Students because, during their learning time, they can make the payment by less payment, and later, after completing the studies, they can make payment when they start earning. Due to this, a student can do higher studies by facing less burden of payment of an installment on earlier stages.
#3 – Useful for Seasonal Business
There is some business that is not operated for the whole year. Rather these are running only in specific seasons; therefore, this type of loan option is useful because the borrower can make less payment during the off-season and make higher payment during the season.
Drawbacks of Negative Amortization
#1 – Increase in Principal Amount
In negative amortization principal amount will increase because the borrower is making lower interest payment which they need to pay and this difference will be added to the principal amount, and the gradually principal amount becomes more than the value of assets, and it is riskier if the borrower will not be able to make payment in future also.
#2 – Payment of Interest on Interest
– Since in negative amortization, borrowers are making interest payments less than the interest accruedInterest AccruedAccrued Interest is the unsettled interest amount which is either earned by the company or which is payable by the company within the same accounting period. on loan; therefore, the remaining interest will be added to the principal, and interest will be charged on this additional amount. It means the borrower has to make payment interest on interest.
Negative amortization is a type of amortization in which the borrower can choose to make payment as per his financial condition, and it is not required to make the payment monthly equal installment as per standard amortization rate. Rather he can make lesser payment of interest, but at the same time remaining interest amount will be added to the principal, and the borrower can make payment of the total principal amount with interest at a later period.
This is a very riskier option because the principal amount will increase after every installment, and after some time, the principal amount will become more than the value of assets, and secondly, the borrower is paying interest on interest also.
This has been a guide to what is Negative Amortization and its definition. Here we discuss the example of negative amortization along with its benefits and drawbacks. You can learn more about finance from the following articles –