Adjustable rate mortgages are a type of reverse amortization.
Reverse amortization – also called negative amortization in the lending business – is a concept where loan amortization works backwards. On a regular loan, like a mortgage, borrowers must pay a specific principal amount each month, plus interest. Interest starts pretty high on these loans, typically several hundred dollars, compared to just a few hundred dollars of principal repayment. Reverse amortization charges lower interest amounts at the beginning of the loan and then increases as the borrower makes payments. A very common loan that works this way is an adjustable rate mortgage, although some types of reverse mortgages can also work this way.
On a regular loan, like a mortgage, borrowers must pay a specific principal amount each month, plus interest.
The purpose of reverse amortization is to make borrowers receive fewer upfront payments, which allows them to repay the loan more easily. As the loan progresses, the borrower is likely to expect to increase its income to offset the increase in principal and interest payments. For example, business loans can work this way, using advance payments. Initial payments are low for new businesses, as these companies often don’t have enough cash flow for large loan payments. After three to five years, a large balloon payment comes in, with a large portion of that payment going towards interest, which compensates for the low payments in the first few years of the loan.
Some types of reverse mortgages can operate in the form of reverse amortization.
Residential mortgages are the other type of loan where reverse amortization is predominant. Here, mortgages can be called adjustable rate mortgages (ARMs), which means that the loan starts with a low interest rate and increases at specified intervals. For example, an ARM of 5/1 indicates a potential annual percentage increase in the loan’s interest rate after five years. This mortgage loan results in reverse amortization as interest rates almost always increase, making the loan more expensive. ARMs are also dangerous loans because payments increase and borrowers may not be able to keep them.
Most lenders provide some sort of amortization chart or other schedule to explain the effects of reverse amortization. A safe understanding is necessary as these loans can end up being much more expensive than traditional loans, resulting in lower payments at the beginning of the loan period. Also, the information is required for those individuals who do not plan to have the loan for the entire term of the loan. Borrowers can take advantage of reverse amortization by paying off the loan or selling the property within the initial ARM period. Essentially, this is a money-saving technique when borrowing money from lenders.