Negative amortization loans can be a positive strategy for homeowners, particularly for farmers or freelancers who receive their cash several times a year in large amounts but who lack a regular salary, or for low-income homeowners who do not want to throw their hard-earned money away on rent but who cannot absorb the financial burden of traditional loans with ever increasing interest payments. Negative amortization loans have a deserved reputation for being risky financially, but with the right information and fiscal discipline, a borrower can make negative amortization loans work to his or her advantage.
What is negative amortization? Amortization is the term denoting the procedure by which a balance on a loan is gradually reduced through regular payments on the loan. If you have a loan with a fixed payment cap and wish to maintain the same level of payment without having interest increases added, these increases revert to the balance. This is called negative amortization. Let’s say you don’t want to pay any more than $500 a month on a $100,000 loan. This monthly payment with the interest payment added to it would amount to $525. With a negative amortization loan, you agreed to pay only $500, so the interest is added to the balance; for that month, your balance will increase to $100,025. This means that your balance will continue to increase for the life of your loan.
Sound scary? It can be, and that is the reason many experts do not recommend negative amortization loans. However, for borrowers who value cash flow over home equity and whose monthly income fluctuates from month to month, negative amortization loans are an option if the borrower proceeds with caution. First, as with all loans, do extensive research to find the best rates. This means looking in the newspaper, asking friends, or talking to several brokers until you find a good deal. You might consider paying a slightly higher fee to the broker; in many cases, the more you pay the broker, the lower your rate will be. Once you find the right broker, ask for an adjustable rate mortgage and read the fine print. You should know how often the payment will change, and how much of each payment will be interest, or negative amortization. Be sure to find a negative amortization loan that gives the option of paying more per month on the loan if you are able. The best way to handle negative amortization is to view it as a safety net rather than a situation. To avoid ending up with a balance that is higher than the cost of your home, pay more than the minimum when you can to reduce your balance. For instance, if you work freelance and receive three months’ worth of pay at a time, but you tend to be low on cash right before your payments come in, rely on negative amortization during the lean month, and pay off the interest that was added to the balance as soon as you are paid. This way, you are taking charge of your negative amortization loan and maintain a reasonable balance.
To prevent your balance from ballooning, choose negative amortization loans with caps that do not exceed, for instance, 125% of the original amount. Review the plan carefully; there are some negative amortization loans that allow the lender to collect interest which is not collectible for traditional loans. Remember that while negative amortization loans give you more freedom, they require more vigilance and fiscal discipline.
