Negative Amortization

In finance, the term negative amortization refers to the practice of making debt amortization payments which are lower than the interest payments charged on a loan. This results in the debt growing rather than diminishing over the loan term.

Negative amortization loans may be loans with fixed monthly repayments which do not cover amortization and interest in full, or they may be loans with fixed monthly repayments but variable interest rates.

Example 1: A lender offers a 100,000-Swiss-franc loan with a fixed monthly repayment of 500 francs at the end of each month, a 10-year term and an interest rate of 9% per annum. The fixed monthly repayments over the course of 1 year total 6000 francs, and over the course of the 10-year term the required repayments total 60,000 francs. However, the actual monthly repayment needed in order to fully amortize the loan is around 1248 francs per month. So the monthly deficit is 748 francs. At the end of the loan term, the borrower would still owe around 89,760 francs. This would either have to be repaid as a lump-sum (see: Balloon loan) or by means of a new loan.

Example 2: A lender offers a 100,000-franc revolving loan which requires a fixed annual interest payment of 10% per annum paid at the end of each year. The annual interest rate is variable – in this case the lender can change the rate every year. Interest is compounded annually. A borrower holds the revolving loan for 10 years. The first 2 years, the interest is lower than the monthly repayment, at 9% per annum. The interest rate for the third and fourth year is 10% per annum (equal to the annual repayment). In the fifth and sixth year the interest rate goes up to 13% per annum, and in the seventh and eighth year the lender charges 12% interest per annum. In the ninth and tenth year the interest rate has gone down to 10% per annum. The average annual interest rate for this revolving loan is 10.8% per annum – a full 0.8% higher than the amount covered by the 10% annual interest payment. That unpaid 0.8% interest charge will be added to the 100,000-franc loan principal. Taking annual compounding into account, the unpaid interest would add just over 8,294 francs to the loan principal over the 10-year term. So the original debt of 100,000 francs would end up being 108,294 francs due to negative amortization.

Negative amortization can be useful when a borrower wants to obtain a large amount of capital at a low cost. For example, a business owner or investor may use a negative amortization loan to access affordable capital in order to fund a timely investment which will deliver high returns. However, it is important to understand that negative amortization will – in almost every case – result in a more expensive loan.

The Swiss Consumer Credit Act stipulates that personal loans must be amortized in full by means of identical payments over the loan term. Negative amortization of personal loans is illegal in Switzerland. However, it may be used for specialized loan types which do not fall under consumer credit laws.

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