Negative Amortization

Negative Amortization Definition

Negative amortization refers to a situation when a loan borrower makes a payment less than the standard installment set by the bank. Therefore, the excess interest amount over the installment amount is added to the principal amount of the loan. It occurs because the borrower’s payments do not cover the total amount of interest accrued.

Example of Negative Amortization Loan

Mr. X took a loan of $3,00,000 at 12% p.a. from the bank for ten years, i.e., it will be paid in 60 monthly installments.

In the normal amortization schedule, Mr. X has to pay the equal monthly installment and the principal amount of the loan will reduce after each subsequent payment. 

Extract of 12 monthly installment repayment

Negative Amortization - Example 1.1

However, in a negative amortization scenario, the bank offers Mr. X the “Choose Your Payment” option. As a result, the borrower can make less payment in every installment as per their 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.read more will increase after the payment of every installment.

In the above example, if Mr. X has to pay only interest, it will be $3,000 every month. But in negative amortization, Mr. X can choose a lesser amount to pay, which increases the principal amount. As a result, Mr. X will be paying only $2,000 per month. Therefore, in the first month, there will be a short payment of $1,000, and the principal amount will increase by $1,000 and. In this manner, at the end of the 1st year, the principal balance will be $312,683.

Extract of 12 monthly installment repayment in negative amortization

Negative Amortization - Example 1.2

Benefits of Negative Amortization

#1 – Business Expansion

In the initial stage, business organizations opted for this scheme because they were not required to make payments per the bank’s standard amortization installment. Instead, they can choose to pay as per their comfort 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.read more for business expansion or pay higher installment at a later stage.

#2 – Help in Higher Studies of Students

Negatively amortizing loans help students reduce the amount to be paid in their learning stage. After completing their education, they can make payments when they start earning. Thus, a student can pursue higher studies by facing less loan installment payment burden.

#3 – Useful for Seasonal Business

Some businesses do not operate for the whole year. Instead, they run only in specific seasons. This type of loan option is helpful because the borrower can make fewer payments during the off-season and make higher payments during the season.

Drawbacks of Negative Amortization

#1 – Increase in Principal Amount

In negative amortization, the principal amount increases because the borrower makes lower interest payments than they need to pay, and this difference gets added to the principal amount. Therefore, gradually, the principal amount becomes more than the value of assets, and it is riskier if the borrower will not be able to make payment in the future.

#2 – Payment of Interest on Interest

In negative amortization, borrowers make minor interest payments 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.read more on the loan. Therefore, the remaining interest is added to the principal amount, and interest gets charged to this additional amount. It means the borrower has to make payments on subsequent interest amounts.

Conclusion

Negative amortization is a type of amortization in which the borrowers can choose to pay per their financial conditions. It is not required to make equal monthly payments per the standard amortization rate. Instead, they can pay a lesser amount of interest. However, at the same time, the remaining interest amount gets added to the principal loan amount. The borrower can pay the total principal amount with interest at a later period.

This is a riskier option because the principal amount will increase after every installment. Furthermore, the principal amount will become more than the value of assets after some time, and the borrower will need to pay interest on interest.

This has been a guide to what is Negative Amortization and its definition. We explain the calculation of negative amortization loans along with examples, benefits and drawbacks. You can learn more about finance from the following articles –

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