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Always beware the “negative amortization” mortgage loan. First, learn before you ever even make an application whether the mortgage you're considering is a negative amortization or potentially negative amortization loan. Second, examine very closely any disclosures given to you by your potential mortgage lender that explain how this type of loan might work.
An example of a negative amortization mortgage will make more sense than a long technical explanation. Examine this example and you should quickly see what it is and why you must be very careful of using this mortgage type for your financing needs:
Loan amount $200,000
Starting interest rate 4.0% Note interest rate 6.5%
Payment @ 4.0% interest $961.34
Total mortgage payments first year $11,563.08
Interest due at 6.5% first year $13,000.00
Interest deficiency first year ($ 1,463.92)
Amount ADDED to mortgage balance $ 1,463.92
New mortgage balance after first year $201,463.92
As you can see, instead of your mortgage loan balance decreasing by some amount after 12 months of mortgage payments, your balance has INCREASED by over $1,000. What is wrong with this picture, you ask? Your mortgage loan has “negatively amortized” for its first year. Instead of part of your monthly payment being applied to principal to reduce your loan, all of it had to be applied to interest and you still came up short!
Why would anyone want a negative amortization mortgage? Well, no one really wants one. But they serve a valuable purpose at times. Here's how. If you need a mortgage that costs more than you can afford in its early years but your income should increase substantially in the near future, the dramatically lower starting payment of a loan like this may allow you to qualify to purchase the home you want. Then, either calculate the correct payment at the note rate plus some amount you can afford to pay towards principal, and then pay this amount every month. Or negotiate terms that state your monthly payment will revert to a “fully amortizing” payment in the future, and begin making that regular payment as scheduled. This allows you to buy the home you want, afford monthly payments at lower than market interest rate at the beginning, and provide you with normal balance pay down in the future.