financing arrangement in which monthly payments are less than the true amortized amounts and the loan balance increases over the term of the loan rather than decreases; the interest shortage is added to the unpaid principal. In some cases, the interest shortage is added back to the loan and payable at maturity. For example, amortized payments for the first six months of a 30-year mortgage loan would be based on a 13% rate, but interest would be charged against equity at 18%; this rate charge would fluctuate every six-month period. In some loans, the negative amounts may be made up by applying such deficits against the borrower's down payment equity. Federal law requires mortgage lenders to make sure that borrowers understand the potential impact of negative amortization in several interest rate scenarios through a series of extensive disclosure documents.

increase in the principal of a loan, when the loan payments are insufficient to pay the interest due. The unpaid interest is added to the outstanding loan balance, so the principal increases, rather than decreases, as payments are made. This situation typically occurs in an adjustable-rate mortgage with an annual cap limiting any increases in the interest rate, and also in a Graduated Payment Mortgage (GPM) , which has low initial payments so moderate-income borrowers can afford to make the loan payments. Negative amortization can occur on a potential basis (when deferred interest exceeds borrower optional payment caps) or scheduled basis (provided for by loan documents).

increase in the outstanding balance of a loan resulting from the failure of periodic debt service payments to cover required interest charged on the loan. It generally occurs under indexed loan for which the applicable interest rate may be changed without affecting the monthly payments. Negative amortization will occur if the indexed interest rate is increased and the payment is less than the interest required.

an increase in the outstanding balance of a loan resulting from the failure of periodic debt service payments to cover required interest charged on the loan. Generally occurs under indexed loan for which the applicable interest rate may be changed without affecting the monthly payments. Negative amortization will occur if the indexed interest rate is increased.

Example: A $100,000 loan is originated at 8% interest with a maturity of 30 years. The interest rate may be adjusted each 6 months, but monthly payments remain a constant $733.77. After 6 months, the interest rate is raised to 9%, which would require a monthly payment of $804.01 to fully amortize the loan. At the new interest rate, $746.93 is required to pay interest. The $13.16 difference between the payment and interest due is added to the principal in month 7 as negative amortization (Figure 128).