When the amount that you owe on a loan increases despite regular monthly payments

Negative amortizationii typically happens with an adjustable rate mortgageii (ARM) that has a payment capi. This means that your monthly paymenti can only increase up to 7.5% from the last adjustment periodi.

Here's how this type of loan works: the lender gives you three
options on how to pay your monthly loan payment. Typically, you
can pay (1) the full amount that's due, which covers both the principali and interesti (2) the amount based on the payment cap or (3) interest only.

If you select the second method, you're at risk of negative amortization - if the loan's interest ratei shoots up, you owe more money than what the payment cap accounts for. This unpaid interest is then tacked onto your loan. So, your loan balance creeps up instead of shrinking. Similarly, with the third method, the amount that's not paid on the principal is added to your loan.

This type of loan makes sense for people and companies who have seasonal or staggered incomes, or for people who want more flexibility and can manage their finances with daily updated spreadsheets.

Example: How can negative amortization occur on an $200,000 ARM at 8% interest that has a payment cap of $500?

With option 2, the $212 difference between the full payment and
the payment cap is added to your loan principal, causing negative
amortization. Option 3 also results in negative amortization since
the $112 difference between the full payment and the interest-only
payment is added to your loan