Negative amortization loans, also known as deferred interest loans, neg am and payment option ARMs (adjustable rate mortgages), are home financing options that have payment adjustment caps in addition to interest rate adjustment caps. This means that even though the loan's interest rate may increase, your payment will generally stay the same. As housing prices skyrocketed, these loans became more popular because they gave homebuyers more power to purchase more house for a lower initial cash outlay. The 1% start rate also makes house payments more affordable for the first few years of the loan.

How Negative Amortization Occurs

A mortgage is largely figured by using the loan amount, the interest rate and the number of years to pay back the loan. Traditional mortgages consist of monthly payments to cover interest and a gradual reduction of the principal (amortization). With negative amortization loans there are payment caps that limit the amount of payment increases, but not interest-rate increases. As a result, the minimum payments do not even cover the monthly interest. The shortfall is automatically added to your loan balance, causing the principal balance to increase rather than decrease.

Neg-Am and Option ARM Risks

If you make the minimum payment, in addition to the unpaid interest being tacked onto the loan balance, additional interest may be charged on the shortfall. So, the deferred interest can take your equity and cause you to owe more than what the house is worth over time.

Comptroller of the Currency John C. Dugan said regulators are especially concerned about negative amortization loans in real estate markets entering down cycles: "If real estate prices decline -- and there already is evidence of softening in some markets -- these borrowers could face the bleak prospect of loan balances that exceed the value of the underlying properties." Dugan and other regulators are also worried that many people may not fully comprehend the impending payment shock when the loan adjusts to fully indexed payment.

The federal financial regulatory agencies express concern over the fact that these low payment home buying options are offered to a wider spectrum of buyers who may may not otherwise qualify for a similar-size mortgage under traditional terms and underwriting standards. And, institutions are increasingly combining these loans with other features that may compound risk ("risk layering") including reduced or no documentation loans, and the 100% 1st mortgage, also known as a no money down home loan or 80-20 loan because of the typical 1st mortgage that covers 80% of the purchase price and simultaneous piggyback 2nd for the 20% balance.

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