What does negative amortization indicate about a loan?

Negative amortization occurs when the payments made on a loan are insufficient to cover the interest that accrues during a given period. This means that the unpaid interest is added to the principal balance, causing it to increase rather than decrease over time. When the payment is lower than the interest due, the borrower essentially incurs additional debt, leading to larger future payments and potential repayment challenges.

This characteristic is particularly relevant in certain loan types, such as adjustable-rate mortgages or certain kinds of student loans, where the initial payments may be set lower to attract borrowers. Understanding negative amortization is crucial, as it highlights the risks associated with making smaller payments than what is required to effectively manage a loan’s principal and interest over time.