Negative amortization

Key Takeaways

• Negative amortization occurs when a scheduled payment is smaller than the interest accruing that month, so the unpaid interest is added to the principal balance.
• A borrower in negative amortization can owe more than the original loan amount even though every payment was made on time.
• Washington law bars a financial institution from making or facilitating a residential mortgage loan that imposes negative amortization under RCW 19.144.050.
• A Qualified Mortgage under the federal ability-to-repay rule may not carry a negative amortization feature.

What It Means

Negative amortization runs a loan backwards. A mortgage payment is supposed to cover the interest that accrued since the last payment, with whatever is left over reducing the principal, and that normal process is amortization. When the scheduled payment is smaller than the interest owed, nothing is left over. The lender adds the unpaid interest to the principal balance, and the borrower starts paying interest on interest.

The Consumer Financial Protection Bureau describes the result plainly: even when you pay, the amount you owe still goes up. Loan designs that can produce it include payment-option adjustable rate loans that offer a minimum payment choice, deeply discounted introductory rates, and graduated payment plans whose early payments are set below the interest cost.

The damage lands on equity. A borrower who never misses a payment can still owe more each year than the year before, and more than the home is worth if values flatten. A rising balance also pushes the Loan To Value Ratio up instead of down, which can block a refinance at the moment refinancing would help most. Normal Amortization does the opposite and shrinks the debt.

How It Works in Washington

In Washington, negative amortization is restricted rather than merely disclosed. RCW 19.144.050 provides that a financial institution may not make or facilitate a residential mortgage loan that includes any provisions that impose negative amortization and which are subject to the interagency guidance on nontraditional mortgage product risks and the statement on subprime mortgage lending. RCW 19.144.010 defines the term for that chapter as an increase in the principal balance of a loan caused when the loan agreement allows the borrower to make payments less than the amount needed to pay all the interest that has accrued.

A federal layer sits on top of that in every state. Under the ability-to-repay rule in Regulation Z, a Qualified Mortgage may not have negative amortization or interest-only payments and may not run longer than 30 years (12 CFR 1026.43(e)(2)), so a loan carrying the feature cannot be a Qualified Mortgage at all.

In Washington the debt itself is secured by a Deed Of Trust under chapter 61.24 RCW. RCW 61.24.020 allows a deed conveying real property to a trustee in trust to secure performance of an obligation to be foreclosed by trustee's sale. That sale chases the balance owed on the day of sale, not the amount printed on the note at closing, which is why a balance that grew is the borrower's problem and not a bookkeeping curiosity.

Example

In 2006, before Washington adopted RCW 19.144.050, Marisol takes a payment-option loan of $300,000 at 6 percent and selects the minimum payment of $1,200 a month.

Month one interest is $300,000 times 6 percent divided by 12, or $1,500. Her $1,200 payment leaves $300 of interest unpaid, and that $300 is added to principal, so she owes $300,300. Month two charges interest on the larger balance, $1,501.50, so the shortfall grows to $301.50 and the balance reaches $300,601.50. Month three adds another $303.01.

After twelve on-time payments Marisol owes $303,700.67. She has paid $14,400 over the year, and her debt is $3,700.67 higher than the day she signed.

Common Mistakes and Exam Traps

• Negative amortization is not a balloon payment. A balloon loan leaves a large principal sum due at maturity by design, while negative amortization grows the balance month by month because payments fall short of the interest.
• Paying on time does not prevent negative amortization. The trigger is a payment smaller than the accrued interest, not a late or missed payment.
• An interest-only payment is not negative amortization. Paying exactly the accrued interest holds the balance level, while paying less than the interest makes it rise.
• The restriction in RCW 19.144.050 falls on the lender, not the borrower. The statute bars a financial institution from making or facilitating the loan.