In an adjustable-rate mortgage, what does the term 'negative amortization' refer to?

In the context of an adjustable-rate mortgage, 'negative amortization' refers to the situation where payments made by the borrower are insufficient to cover the interest expense that accrues on the loan. When this occurs, the unpaid interest is added to the principal balance of the mortgage, leading to an increase in the total amount owed over time.

This situation can often arise in loans where the borrower opts for lower initial payments, which may not cover the accumulating interest, especially during periods of rising interest rates. As a result, instead of reducing the loan balance, the borrower’s debt can actually increase, creating a challenging financial situation in the long run.

Understanding this concept is crucial for borrowers considering adjustable-rate mortgages, as it highlights the risks associated with insufficient payment structures and the importance of managing loan payments effectively.