Negative amortization occurs when your monthly payments are not large enough to cover all the interest due on the loan. The unpaid interest is added to the unpaid balance of the loan making your overall balance higher than the prior month rather than lower. The danger of negative amortization is that the buyer ends up owing more than the original amount of the loan.
Before you can fully understand what negative amortization is and how it happens, you need to know what amortization is. Amortization refers to the way your debt decreases and is eventually eliminated on a certain date as you make payments. In a fully amortizing loan, you typically pay monthly, in amounts calculated to repay your total principal plus interest by a certain date. A longer loan term means smaller payments, but higher costs overall. A shorter term means larger payments but lower costs and paying off the total debt faster.
Negative amortization is also known as being upside-down in a loan. With cars loans and mortgages, this can happen if you extend the life of your loan by refinancing, but don't end up keeping the car or home as long as the loan lasts. When that happens, you can end up owing more on your car or home than you can sell it for and that can be dangerous for your finances.
If you get a negative amortization loan, you should know the pros and cons. On the plus side, if the interest rate on your adjustable rate mortgage4 (ARM) increases, your payments will remain the same and you won't have to scramble for cash each month. On the other hand, the extra expense due to higher interest rate will be added to your outstanding balance, so it may take longer to repay your debt.