Keep up with the interest on your mortgage payments
Each monthly mortgage payment comes with the satisfaction that you're paying down your loan a little more and coming closer to owning your home outright. But it can also be a little frustrating to see how much money goes toward interest instead of chipping away at the principal and increasing your equity in the property.
Many loans put funds in escrow to go toward local property taxes as well as homeowners insurance. Of the amount used for the loan payment itself, only a portion will pay off the principal while the remainder goes to interest collected by the lender. The share of interest is highest at the outset of the loan, and gradually shrinks over time as the principal is whittled down.
Some loans offer negative amortization, which allows the borrower to pay less interest on any given monthly payment. However, this amount must still be paid eventually and might lead to ballooning payments in the future. For this reason, negative amortization has often been described as a predatory lending tactic; according to the National Conference of State Legislatures, it has been banned in 39 states, including Connecticut and Rhode Island.
Amortization is a standard way to set principal and interest payments over the course of a loan. Justin Pritchard, writing for the financial site The Balance, says the lender calculates the monthly payment based on factors such as the loan balance, interest rate, and how long the loan's term is. The monthly payment remains the same over the entire loan, though the share going toward interest is reduced over time.
With a negative amortization loan, the borrower has the option of making a minimum payment that doesn't cover all of the interest for the month's payment. The Consumer Financial Protection Bureau says any unpaid interest is added to the principal, thus increasing the principal balance you owe to the lender.
Adjustable rate mortgages may include negative amortization in their terms. Will Kenton, writing for the financial site Investopedia, says payment option adjustable rate mortgages allow the buyer to make the full payment, an interest only payment, or a minimum payment that covers only part of the interest. Graduated payment mortgages work in negative amortization at the outset, starting with payments that don't cover the interest. The payments later increase to cover the interest as well as the amount that was added to the principal at the start of the loan.
Negative amortization carries the obvious disadvantage of failing to cover the full mortgage payment, increasing the amount you owe to the lender and raising the cost of your monthly payment when the loan costs are recalculated at some point in the future. The Consumer Financial Protection Bureau says this increases the likelihood that the amount you owe the lender will exceed your property's value, or puts you at a greater risk of foreclosure if you have trouble making the higher monthly payments.
However, borrowers have sometimes preferred negative amortization loans. Pritchard says homeowners may appreciate the ability to make a more modest payment if they have another expense or are otherwise experiencing a temporary financial crunch. A buyer may also use negative amortization in order to afford a home that is out of their price range in the expectation that they'll later have enough income to afford making the monthly payments in full.
Negative amortization may also appeal to investment buyers. The Pentagon Federal Credit Union, a financial institution in the Washington, D.C. metro area, says buyers may be able to take advantage of low initial payments on this type of loan and sell the property before the higher costs kick in. Investors may also expect that this short-term strategy will work well if property values in a neighborhood are rising substantially.
Of course, these rationales can be risky. The expected boost in income may not materialize, or home values may unexpectedly plummet rather than increase. These circumstances could leave you with an underwater loan or monthly payments where you aren't able to contribute enough to reduce the principal.
If you have a loan with negative amortization, the best strategy is to keep it under control from the beginning. Dan Caplinger, writing for the financial site The Motley Fool, says a loan can quickly grow out of control if the interest is continually added to the principal. Paying more than the minimum amount will stop the loan balance from expanding; you might also set aside some money in a savings account to cover any negative equity if the loan balance ultimately exceeds the home's value.
Refinancing can also help you escape a negative amortization loan that has gotten out of control. David Rouse, writing for SFGate, says you should compare lenders to find the most favorable rate and terms. You'll likely have to make a higher monthly payment, but the amount you owe will be more stable from month to month.
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