A negative amortization loan (neg-am) loan implies that when you take the loan you do not amortize, meaning you do not automatically pay it down over a period of time. Instead, as the loan is being paid down the loan actually gets bigger and you will never pay it off. That is a strict interpretation of negative amortization, that the more you pay the more you owe. Nevertheless, a negative amortization does not mean that literally, it means that it is possible if you do not make the full monthly payments.
A negative amortization loan is an adjustable rate mortgage that has two rates to it. The first rate is the “contract rate,” which is the interest rate you have agreed to pay every month, and the other is the fully indexed rate. Each month you will get a statement showing you the contract rate, which typically is very low and keeps your minimum monthly payments down, and the fully indexed rate, which is the current index plus the margin.
An example of how this loan type works is for example you have a $200,000 negative amortization loan with a fully amortized contract rate of 3.50 percent and a fully indexed rate of 5.00 percent. The 3.50 percent represents a $898 payment while the 5.00 percent means you pay $1,073. Now you have your choice as to which one to pay. You are free to choose either one you prefer, your lender does not care. If you pay the higher amount, you have paid the full interest as well as a small portion of the interest. However, if you have paid the smaller amount, you have added $175 to the principal of the loan.
As you can see the amount of the principal, you owe gets bigger! That is the difference between an interest only loan and one with potential negative amortization. As you can see a negative amortization loan can be wonderful for the low interest rates that are available, however for those looking to pay off their house they are not a good idea for the long term. I recommend using a negative amortization loan only temporarily if you choose to go this route. Otherwise, you are likely to become tempted to only pay the minimum balance, thus creating large problems for themselves.
Some people end up losing their homes, because with a negative amortization loan it is quite possible to after a few years of only making the minimum payment for the loan principal to be much higher than the amount that was originally loaned for the mortgage. Most people would agree this is a sign of trouble, however used responsibly a negative amortization loan can have its benefits as I have outlined.