Reverse amortization is a loan concept where interest starts low and increases over time, commonly used in adjustable rate mortgages and business loans with balloon payments. It allows for low initial payments, but can end up being more expensive than traditional loans. Borrowers should understand the effects and seek to pay off the loan or sell the property within the initial period.
Reverse amortization, also called negative amortization in the loan business, is a concept where loan amortization works in reverse. In a normal loan, such as a mortgage, borrowers must pay a specified principal amount each month plus interest. Interest starts out quite high on these loans, often several hundred dollars compared to a few hundred dollars of principal repayment. Reverse amortization charges lower interest amounts at the start of the loan, then increases as the borrower makes payments. A very common loan that works this way is an adjustable rate mortgage, although some types of reverse mortgages can work this way as well.
The purpose of reverse amortization is to make borrowers receive low prepayments, which makes it easier for them to repay the loan. As the loan progresses, the borrower likely expects increased income to offset the increased principal and interest payments. For example, business loans can work this way using balloon payments. Down payments are low for new businesses, as these companies typically don’t have enough cash flow for large loan payments. After three to five years, a large balloon payment emerges, with a large portion of this payment going toward interest, making up for low payments in the early years of the loan.
Home mortgages are the other type of loan where reverse amortization is prevalent. Here, the mortgages may be called Adjustable Rate Mortgages (ARMs), which means that the loan starts at a low interest rate and then increases at specified intervals. For example, an ARM of 5/1 indicates a potential annual percentage increase in the interest rate on the loan after five years. This home loan results in a reverse amortization since interest rates almost always increase, making the loan more expensive. ARMs are also dangerous loans because payments increase and borrowers may not be able to keep up.
Most lenders provide some type of amortization schedule or other schedule to explain the effects of reverse amortization. A safe understanding is necessary as these loans can end up being much more expensive than traditional loans, giving lower payments at the beginning of the loan period. Also, the information is necessary for those people who do not plan to get the loan for the entire loan period. Borrowers can seek to take advantage of reverse amortization by paying off the loan or selling the property within the initial ARM period. Essentially, this is a technique for saving money when lending money to lenders.
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