Wednesday, September 18, 2013 / by William Culp
If you’re applying for a mortgage for the first time, it may feel like you’re learning a second language. All of the terms and regulations can seem daunting. One that doesn’t need to be is “amortization,” which is just the act of paying off debt in regular installments over a period of time.
When you amortize a loan you basically pay off the principal by making regular installment payments; the process typically takes place gradually over several years.
Another term you may be hearing is “negative amortization.” What is the difference? When your monthly payment isn’t enough to cover the loan interest, then your loan principal increases rather than decreases. This is called negative amortization, otherwise referred to as “deferred interest.”
Negative Amortization causes the loan balance to increase rather than decrease.This often happens with adjustable rate mortgages (ARMs). Negative amortization has to be repaid, which means your payment will rise in the future. The larger the negative amortization, the more you will be required to amortize the loan in full.
So you may be wondering, why would anyone use a negative amortization loan?
The main reason people use negative amortization loans is to lower monthly payments. Some homeowners use loans with negative amortization to purchase a house they otherwise can’t afford, resting on the idea that in the future, they will have more income and can make larger payments.
With negative amortization, a persistent rise in interest rates reduces the equity in the house unless the negative amortization is offset by house appreciation. As a result, some use negative amortization if they believe that the house will be worth much more in the near future.
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