What does the term 'negative amortization' refer to?

The term 'negative amortization' specifically refers to a scenario in which monthly payment caps lead to an increasing loan balance. This occurs when a borrower’s payments do not cover the full amount of interest that accrues on the loan. When this happens, the unpaid interest is added to the principal balance of the loan, causing the overall loan amount to increase over time rather than decrease.

This concept is critical for borrowers to understand, as it can lead to financial difficulties if the loan balance continues to grow, potentially exceeding the original loan amount. It's particularly common in certain types of mortgage products, such as adjustable-rate mortgages with payment caps. Knowing about negative amortization helps borrowers make informed decisions regarding their financial commitments and the implications of their loan terms.

Other options do not accurately describe negative amortization. For instance, paying down the principal faster than required would indicate a positive reduction in the loan, not an increase. Lowering the interest rate exponentially does not relate to the concept of amortization directly, and payments applied to interest only would typically mean that the loan balance remains unchanged rather than increasing.