An increase in the principal balance of a loan caused by making payments that fail to cover the interest due. The remaining amount of interest owed is added to the loan's principal, which ultimately causes the borrower to owe more money.
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For example, if the periodic interest payment on a loan is $500 and a $400 payment may contractually be made, $100 is added to the principal balance of the loan.
Adjustable-rate mortgages with a negative amortization feature are typically known as payment option ARMs. Fixed-rate mortgages with this feature are known as graduated payment mortgages.
While these mortgages can provide borrowers with the ability to make low monthly payments for a short time, the monthly payments must increase substantially at some point over the term of the mortgage. The date or dates when payments increase on a fixed-rate graduated-payment mortgage are known with certainty. Payment option ARMs also have scheduled payment increases, but they carry triggers that can cause the mortgage to recast before a scheduled payment increase. As a result, payment option ARMs carry a great deal of payment shock risk.
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