Negative Amortization

In the textbook, we discussed how a loan is normally amortized, with a portion of each payment going toward the interest accrued during the period and the remainder paying down principal. A recent article highlights the dangers of negative amortization, that is when the interest paid each period is less than the interest accrued during that period. One student graduated in 2010 with $50,000 in debt. Because his payments each month did not cover interest, his balance is now $110,000. One study cited in the article finds that 25 percent of student loans in 2009 had a higher balance in 2019 because of negative amortization. Although the article attributes part of the problem to high interest rates (relative to current interest rates), we should note that a fixed interest rate also guarantees that the interest rate won't rise. In other words, the optimum choice of fixed versus variable rate is generally only knowable in hindsight. The real issue is granting a negative amortization loan. Of course, the only negative amortization lender we know of is Uncle Sam.