What characterizes a negative amortization loan?

A negative amortization loan is characterized by a situation where the principal balance increases over time, even though regular payments are being made. This occurs when the borrowers' payments are not sufficient to cover the interest accrued on the loan. As a result, the unpaid interest is added to the principal balance, causing it to grow rather than decline.

In this type of loan, the borrower might be drawn in by an initially low payment, often seen in adjustable-rate mortgages or loans with special features aimed at making the mortgage more affordable in the short term. However, failure to pay down the principal can lead to significant financial challenges if the borrowing terms become less favorable or if the borrower needs to sell the home.

Understanding this mechanism is critical, as it highlights the potential long-term risks associated with negative amortization, making it essential for both lenders and borrowers to be aware of how these loans function.