What is meant by 'negative amortization'?

Negative amortization occurs when the payments made on a loan are insufficient to cover the interest due for that period, leading to an increase in the outstanding principal balance. As a result, despite the borrower making regular payments, the total amount owed actually grows. This typically happens in scenarios such as adjustable-rate mortgages, where lower initial payments can be offered, but may not fully cover the interest costs, resulting in the borrower owing more than when they started.

This concept can be particularly concerning for borrowers, as it effectively shifts the liability rather than reducing it, creating a longer path to eventual loan payoff. Understanding negative amortization is critical for assessing the long-term financial implications of certain loan structures, ensuring borrowers are aware of the possibility of increasing debt burdens even while making regular payments.