What happens to a loan in negative amortization?

In a situation where a loan experiences negative amortization, the principal balance of the loan increases over time rather than decreasing. This occurs when the payments made are insufficient to cover the interest accruing on the loan. In such cases, the unpaid interest is added to the principal balance, leading to an overall increase in the amount owed.

This is particularly common in certain types of loans, such as those with adjustable rates or balloon payments, where the initial payment amounts may be lower than the interest accruing. As borrowers continue to make payments that are less than the interest, the total loan amount grows, resulting in negative amortization.

Other options describe scenarios that do not accurately reflect what occurs in negative amortization. For instance, a decreasing principal balance would imply that payments are sufficient to cover at least the interest, which contradicts the nature of negative amortization. Similarly, stating that payments are always equal to interest overlooks the reality that such loans often entail payments that are consistently below the interest amount, resulting in the principal increasing. Lastly, the idea that a loan is paid off quicker than expected is opposite to the effect of negative amortization, as increasing the principal balance extends the loan term and can lead to larger payments in the future.