What is amortization?
Amortization is the process of repaying a loan and its interest over time, which lowers the balance owed with each payment. For instance, if a company borrows $50,000 for ten years with fixed monthly payments, the interest will be included in the payments. As long as the company pays its debts, the balance will eventually get smaller. An amortization schedule can be made to estimate how long it will take to repay a loan.
What is negative amortization?
The result of a loan’s interest being lower than the payment is negative amortization. Due to the unpaid interest, the principal, or balance of the loan, may rise as a result. If you use negative amortization, your debt can grow if you don’t make enough payments to cover the principal and interest.
Any loan can experience negative amortization, but some loans are more susceptible to it than others. Negative amortization loans are also known as payment in kind (PIK) loans in corporate finance. PIK loans are high-risk business loans because the borrower must pay the interest on the loan with additional debt rather than cash.
Companies typically use PIK loans in a few scenarios:
There are three different PIK loan types, with different interest rates:
How does negative amortization work?
Negative amortization can increase the size of a business loan’s principal payment. Here are some factors that can cause negative amortization:
Inability to pay
Inability to make monthly loan payments in full is one way a business can experience negative amortization with a loan. The lender can increase the total loan amount over time by adding the remaining balance the business owes to it.
Predicting future cash flow
When a company takes out a sizable loan in the hopes that its cash flow will increase, this is another factor that contributes to negative amortization. The loan could experience negative amortization if the company’s prediction is incorrect.
Investors who don’t want to make hefty loan payments occasionally opt for short-term negative amortization. Negative amortization might be advantageous to a business as a short-term financing option. However, this is a risky tactic since it relies on the business making enough money to pay the interest that hasn’t been paid.
Negative amortization solutions
Negative amortization may appear to be a quick fix for a company, but it can cause long-term financial problems for a company. Here are some strategies for companies to solve negative amortization:
Pay the full loan amount or more
If a business has the money, it can pay off the loan in full or more each month to stop negative amortization. Due to this, a business or its accountants may need to drastically alter its spending and budgeting procedures. However, a business can stop negative amortization as soon as it starts making full monthly loan payments.
Refinance the loan
Some lenders might permit a business to refinance its loan in order to help prevent negative amortization. Refinancing is the process of replacing one loan with another that helps settle the debt from the previous loan. For instance, a business might be able to refinance if it has a $7,000 debt on a $5,000 loan that was originally negatively amortized and had a 7% interest rate. A lender may substitute a $7,000 loan with 3% interest for the original loan. The company may be able to repay the loan sooner thanks to the lower interest.
Example of negative amortization
Let’s say a bookstore borrows $10,000 for a term of 10 years at 5% interest, with monthly payments starting after the first year. The owner is aware of the low payments and thinks he can make up for them when he anticipates a rise in book sales.
The table below shows how negative amortization works. Observe how the loan balance for the business grows over time. When no monthly payments are made toward the loan, the principal cost is indicated in parenthesis to indicate that the amount is negative.
What is an example of negative amortization?
For instance, if a borrower only pays $400 toward interest on a loan but the interest payment is $500, the $100 difference would be added to the principal balance of the loan.
Is negative amortization predatory?
Predatory loans are ones that put borrowers at a high risk of default. This would include “negative amortization” mortgages, which let borrowers pay very little each month, causing the balance owed to increase instead of decrease with time.
How do you avoid negative amortization?
Make sure you pay off at least all of the accrued interest with each payment to avoid negative amortization. You’ll owe more money at the end of the loan term if you delay paying interest payments for a longer period of time.