Reverse amortization — also called negative amortization in the lending business — is a concept where loan amortization works backward. On a normal loan, such as a mortgage, borrowers must repay a specific principal amount each month plus interest. The interest starts out quite high on these loans, often several hundred dollars compared to just a few hundred dollars of principal repayment. Reverse amortization charges lower interest amounts at the start of the loan, and then it goes higher as the borrower makes payments. A very common loan that works in this manner is an adjustable rate mortgage, though some types of reverse mortgages may work this way as well.
The purpose of reverse amortization is to get borrowers low early payments, which allows them to afford the loan easier. As the loan progresses, the borrower is probably expecting to increase income in order to offset the rising principal and interest payments. For example, business loans may work in this manner using balloon payments. The initial payments are low for new businesses as these companies do not generally have sufficient cash flow for large loan payments. After three to five years, a large balloon payment comes up, with a large chunk of this payment going toward interest, which makes up for the low payments in the early years of the loan.
Home mortgages are the other loan type where reverse amortization is prevalent. Here, the mortgages may go by the name adjustable rate mortgages (ARMs), meaning the loan starts with a low interest rate and then increases at specified intervals. For example, a 5/1 ARM indicates a potential annual percent increase in the loan interest rate after five years. This mortgage loan results in reverse amortization as interest rates almost always increase, making the loan more expensive. ARMs are also dangerous loans because the payments increase and borrowers may not be able to keep up.
Most lenders provide some type of amortization chart or other schedule to explain the effects of reverse amortization. A sure understanding is necessary as these loans can wind up being much more expensive than traditional loans, giving lower payments early in the loan period. Additionally, information is necessary for those individuals who do not plan on having the loan for the entire loan period. Borrowers may look to take advantage of reverse amortization by paying off the loan or selling the property within the initial ARM period. Essentially, this is a money-saving technique when borrowing money from lenders.