NEGATIVELY AMORTIZING LOANS

An interest-only loan at least keeps the loan amount from increasing, by paying ongoing interest charges. A negatively amortizing loan does not even do that much. With such a loan, the monthly payments are not even enough to cover the interest, which accrued that month. Thus, with a negatively amortizing loan the total amount, which the borrower owes – principal plus accrued but unpaid interest – increases every month.

Negatively amortizing loans are very dangerous. They were commonly made, in the late 1980s, in the last phases of the commercial property boom, upon commercial projects, which made no economic sense. They became common, once again, in the years between 2003 and 2006, in sub-prime residential real estate deals. In both cases, the alleged logic of such loans was that market values were rising so quickly that the borrower soon would be able to sell the property, for more than the loan, or re-finance at more attractive rates. While the boom continued, this logic made a dangerous kind of short-term sense. Once the boom blew up, of course, these loans predictably became disasters for all concerned.

One advantage of negatively amortizing loans is as a market signal. When such loans become common, it is a very strong sign that the real estate market is overheated and that a particular boom is reaching its end. When such loans come back – and they will – prudent investors should consider taking their profits and getting out of the market.

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