negatively amortized. what does that even mean?

I’ve had more and more calls from people who tell me their bank has called them to inform them that they are negatively amortized. Based on today’s article by CBC News, “the banking regulator says about 250 Billion worth of mortgages are either currently or soon to be negatively amortized”, so I expect that the number of calls will start to rise. That said, let me explain how “Negative Amortization” works.

When a mortgage is negatively amortized, it means that the borrower's monthly payments are insufficient to cover the interest costs and do not fully pay down the principal balance of the loan. As a result, the outstanding balance of the mortgage increases over time rather than decreasing, which is the typical scenario in a standard amortizing mortgage.

In other words, it's like not keeping up with your bills. The money you pay each month isn't enough to cover all the interest you owe, so not only are you not paying down the principal, you aren’t covering your interest payments, so the amount you owe gets bigger and bigger over time.

Negative amortization is usually found in variable rate fixed payment mortgages, like ones where you pay the same amount for your term. While it might seem convenient to have the same payment every month and potentially pay down your mortgage faster if interest rates decrease, it does have negative consequences when interest rates increase like they do today. When interest rises, the larger portion of that payment on these types of mortgages goes toward interest, slowing down the rate at which the principal is paid off. Even worse, when interest rates increase significantly, the payment doesn’t cover the interest payment.

Mortgages are negatively amortized for Two reasons:

1. Borrowers aren’t up to date with their interest payments, where the difference between the interest accruing on the loan and the actual payment made by the borrower is added to the mortgage's principal balance. This unpaid interest is sometimes referred to as "deferred interest."

2. And, they have a growing loan balance: When the unpaid interest accumulates and is added to the principal, the outstanding balance of the mortgage increases. This means the borrower owes more on the loan than they initially borrowed.

So what happens in this situation?

Banks typically want you to take certain actions when your mortgage is negatively amortized. Here are some common steps that banks may recommend or expect from borrowers:

1. Increase Your Payments: Ideally, banks will want you to increase the monthly mortgage payments to cover the full interest costs, pay down some of the principal balance and prevent the loan balance from growing further.

2. Switch to a Fully Amortizing Loan: Depending on the terms of your existing mortgage, the bank may suggest you switch to a fixed rate or a fixed payment mortgage. This means your monthly payments will be adjusted to ensure you pay the principal and interest, gradually reducing the loan balance.

3. Refinance the Mortgage: Again, refinancing or replacing your current mortgage with a new one with more favourable terms depending on the terms of your existing mortgage may be a solution, especially if your variable rate is higher than the fixed rates. You will secure a lower interest rate, reduce your monthly payments, and convert your mortgage from a negatively amortized mortgage into a fully amortized one.

4. Pay a Lump Sum: Some borrowers with the financial means to make lump-sum payments toward their mortgage principal can reduce the outstanding balance and mitigate the effects of negative amortization. Banks usually welcome additional payments to reduce the overall debt.

What should you do in this situation?

Ideally, banks would want you to choose options 1 to 3 to reduce their percentage of bad debt. However, in a high inflationary environment like today, preserving your cash flow may be your priority and option four may be the best for you today. That being said, here are the key factors to keep in mind for each option:

Option 1: Increasing Monthly Payments

Factors to consider:

1. Affordability: Can you comfortably afford higher monthly payments? Review your budget to ensure that increasing your payments won't strain your finances.

2. Long-Term Stability: Assess your financial stability and income prospects. Will you be able to sustain the higher payments over the life of the mortgage?

Option 2: Switching to a Fully Amortizing Loan

Factors to consider:

1. Qualification: Check if you qualify for a fully amortized loan based on your credit score, income, and other eligibility criteria.

2. Monthly Payments: Understand how the new monthly payments will compare to your current ones. Ensure they are manageable within your budget.

3. Loan Terms: Review the terms of the new loan, including the interest rate, duration, and any associated fees.

Option 3: Refinancing the Mortgage

Factors to consider:

1. Interest Rates: Compare the current interest rates with the rates on your existing mortgage. Refinancing makes the most sense when rates are lower, allowing you to reduce your monthly payments and potentially shorten the loan term.

2. Closing Costs: Be aware of the closing costs associated with refinancing. Determine how long it will take to recoup these costs through lower monthly payments.

3. Loan Term: Decide whether you want to maintain the same loan term or opt for a shorter one, which may increase monthly payments but save on interest in the long run.

Option 4: Making Lump-Sum Payments

Factors to consider:

1. Financial Resources: Evaluate your current savings or available funds. Can you comfortably make a lump-sum payment without compromising your emergency fund or other financial goals?

2. Impact on Loan Balance: Calculate how much the lump-sum payment will reduce the outstanding mortgage balance and whether it will sufficiently address the negative amortization.

3. Future Payment Adjustments: Determine whether making a lump-sum payment will trigger a recalculation of your monthly payments, which could potentially increase them.

4. Interest Savings: Understand the long-term interest savings that can result from reducing the principal balance through a lump-sum payment.

If you have any questions about your existing mortgage or would like to schedule an appointment to review your existing mortgage, please get in touch with me today!