What does 'negative amortization' indicate about loan payments?

Negative amortization occurs when the payments made on a loan are not enough to cover the interest due, which results in the unpaid interest being added to the principal balance. This means that instead of reducing the principal amount owed, the balance of the loan actually increases over time.

When borrowers are in a situation of negative amortization, their monthly payments may be set lower than the interest accruing on the loan. As a consequence, the amount they owe grows larger, sometimes leading to significant growth in the total loan amount over time. This can be particularly common in certain types of loans, such as adjustable-rate mortgages or zero-interest loans, where the initial payments can be significantly lower than necessary to fully service the debt.

The other answers refer to different aspects of loan agreements but do not accurately describe the nature of negative amortization. This understanding of how payments are structured in relation to loan balances is crucial in real estate finance, particularly for managing risk and ensuring borrowers understand their financial obligations.