Negative amortisation - What is negative amortisation?
Negative amortisation occurs when payments made on a loan are not high enough to reduce the overall amount because the interest charge is higher
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Payments made on a loan must be higher than the rate of interest in order to avoid negative amortisation. These are known as principal payments. Where regular amortisation occurs when a loan is steadily paid off over time, reducing the overall balance, negative amortisation has the opposite effect on the amount due.
Interest rates and negative amortisation
When you take out a loan, you agree to a certain set of specifications including the interest rate. This is usually charged monthly and is essentially payment for borrowing the money.
This interest rate can vary depending on a number of factors such as the particular lender, your personal or business credit rating (depending on the type of loan), the total amount being borrowed, and the inflation rate.
The interest rate is usually a percentage of the total amount borrowed. Some lenders offer an interest-free period to encourage borrowing and quick repayment. It can also be possible to negotiate a better interest rate or take advantage of special offers, especially in the case of credit card debt.
Minimum loan payments and negative amortisation
Most lenders will offer the possibility of making minimum payments on a loan balance. This means that a certain amount must be paid each month in order to prevent the loan from having an impact on the borrower’s credit rating.
In the event that the borrower fails to make the minimum monthly payment, this can result in penalty fees, and can negatively impact their credit rating.
In some cases, the minimum monthly payment is so low that it in fact does not equal the interest charged on the loan. When only the minimum amount is paid in this case, the total balance (principal balance) continues to increase.
An example of negative amortisation
Negative amortisation is commonly seen with loans such as mortgages. If Beth were to borrow £75,000 to purchase a house, with an interest rate of 5% and chose to pay only a percentage of the interest rate for the first year, the lender would add the unpaid interest to the total balance.
Over time, this interest would add up quickly and cause the total due for her loan to increase rapidly. She could end up owing more than the initial £75,000 that she borrowed even within the first 12 months.
Preventing negative amortisation
In order to prevent negative amortisation, it is important that payments made on a loan include the total monthly interest as well as a portion of the principal balance. By making higher payments, you can ensure that your overall loan balance will experience amortisation.
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