The simple definition of negative amortization is the process of shorting a payment in a way that does not cover the cost of interest, with the outstanding balance being applied to the principal of the loan. For example, if the interest payment on a loan is $600, and a payment of $450 is received, the remaining $150 is added to the principal balance. The ability to shorten the payment in such a manner is guaranteed in a contract, and is part of what is known as a payment option adjustable rate mortgage (ARM). On the surface, it seems counter-intuitive to enlarge a principal balance as it adds to the length of the loan and/or increases the monthly payment. However, these loans serve a valid purpose, but are not for everyone.

Shorting the payment in this manner cannot go on indefinitely over the period of the loan. There is a limit set in the contract, one that states that the principal balance cannot go over a certain amount. Typically, the limit is a percentage of the original loan amount. There is no going over this limit. The borrower must start making the agreed upon payment at this point or risk going into default.

Mortgage interest rates on an option adjustable ARM are usually lower in the beginning, but change monthly as various influences come into play. The loan starts out with a low fixed mortgage rate, known as an introductory rate. Monthly payments start changing, typically on a monthly basis, after the introductory period has expired. This gives rise to the possibility that one month's payment will be much higher than the last. It's important to stay on top of the loan to avoid a nasty surprise in mortgage rates.

A loan with negative amortization offers various options for repayment, giving a borrower more flexibility. A borrower can choose from a 15, 30 or 40-year fully amortizing payment, a minimum payment, any amount over the minimum due, and an interest-only payment.

Don't make the mistake of thinking that the minimum payment option is the same as a regular mortgage payment; it is not. The payment is based on the initial low interest rate, which is temporary. During the period that the temporary rate is in place, the minimum payment is the only payment that can be made. No money over the amount can be paid unless there is specific contract language stating that it is allowed. After the initial period expires, the borrower still retains the option to make the low payment, but negative amortization most likely kicks in. This is the point where the payment shortfall is applied to the principal balance.

A negative amortization loan makes the most sense for a buyer who receives year-end bonus payments. This type of buyer makes the minimum payment in order to not stretch their budget, and makes one large payment when they receive their bonus, eliminating the shortages from the minimum payment.