Some ARM loans run the risk of negative amortization, in which the loan’s principal balance is increasing rather than decreasing. Negative amortization occurs whenever the monthly payments are not enough to cover the interest due on the debt. Unless the loan explicitly waives this unpaid interest, that deficit amount is added to the principal balance. This unfavorable situation is a regular byproduct of ARM loans with payment caps. Often, the payment caps so limit the payment adjustment that the new payment calculation is not enough to cover the interest due on the loan. Worse yet, as unpaid interest is added to the principal balance, the borrower will be charged interest on the unpaid interest. Because this situation could lead to endlessly increasing principal balances, ARM loans with payment caps usually also contain principal caps, as a protection against negative amortization. Principal caps still allow negative amortization to increase the principal balance, but sets limits on how high the principal may increase. Most principal caps limit negative amortization increases to 125% of the original loan balance. Thus, an ARM loan with negative amortization and an original balance of $100,000, can have its principal increase to $125,000.
Any unpaid interest after that limit is reached is usually waived by the lender. It would seem apparent that negative amortization is undesirable. But ARM loans with payment caps and negative amortization are still prevalent, because they usually offer very low start rates. For borrowers who intend to keep a loan for only a year or so–even though the loan is amortized for 30 years–these loans could be wise investments.