12.05.2006

The Negative Amortization Trap

The Negative Amortization Trap


Wells Fargo will not make negative amortization loans!

Amortization in general refers to paying back a loan in installments over time. For instance, a 30-year fixed mortgage involves payments that slowly repay the principal amount borrowed over a period of 30 years. Initially, monthly payments are composed mostly of interest; later, as the principal balance outstanding falls, more of each payment goes toward repaying principal.

The need to repay principal increases the amount of each monthly payment. With interest-only loans, the entire payment goes toward interest. Compared to a fixed 30-year mortgage, there are two major differences. First, each monthly payment on an interest-only mortgage is lower; on a $200,000 loan at 6%, using an interest-only mortgage lowers your payment from about $1,200 to $1,000 per month. On the other hand, if you only make interest payments, your principal balance never goes down, so even at the end of 30 years, you would still owe exactly as much money as you borrowed at the beginning. These loans are sometimes referred to as non-amortizing loans, because the payments are calculated never to repay the loan principal.

To lower monthly payments even further, negative amortization loans set payment amounts below the amount of interest due on the loan. For instance, depending on exactly what terms a borrower accepts, payments on a negative amortization loan can be quite a bit lower even than interest-only loan payments. With home prices as high as they have been, some borrowers had to stretch as much as they could to afford a home, and negative amortization loans sometimes gave them the extra edge they needed. However, because the payments are insufficient to cover all the interest, unpaid interest is added to principal, and the outstanding balance on the loan increases over time, rather than slowly getting paid down. Although some larger banks, such as Wells Fargo(NYSE: WFC) and Citigroup(NYSE: C), choose not to make loans that required negative amortization, mortgage brokers can often find other lenders willing to make these loans.


Amortization Table calculation

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