Question 71

Negative amortization occurs when payment is less than accrued interest.

Negative amortization happens when the payments made on a loan are insufficient to cover the interest that accrues over time, resulting in an increase in the total loan balance. This situation typically occurs when the borrower pays less than the interest amount due, causing the unpaid interest to be added to the principal.

A) ARM margin is increased

An increase in the ARM (Adjustable Rate Mortgage) margin does not directly cause negative amortization. The ARM margin refers to the fixed percentage added to the index rate to determine the interest rate, and while it may affect monthly payments, it does not inherently lead to payments being less than accrued interest.

B) payment is interest-only

While an interest-only payment structure may lead to situations where the principal balance does not decrease, it does not specifically indicate negative amortization. If the payment is structured to cover only interest and the loan terms do not allow for any principal reduction, this could lead to a flat balance rather than an increasing one, which is not the essence of negative amortization.

C) payment is less than accrued interest

This option correctly identifies the condition for negative amortization. When a borrower makes payments that do not cover the total interest accrued, the unpaid interest is added to the principal balance, resulting in a growing loan amount over time. This is the definitive characteristic of negative amortization.

D) index is adjusted

Adjustment of the index refers to changes in the benchmark interest rate that may affect the overall cost of a loan. However, the adjustment itself does not determine whether negative amortization occurs. It is the payment relative to interest accrued that is critical, not merely the adjustment of the index.

Conclusion

The correct answer, C, directly addresses the condition for negative amortization, where payments are insufficient to cover accrued interest, leading to an increase in the loan balance. Options A, B, and D do not accurately describe the mechanics of negative amortization, demonstrating why they are incorrect. Understanding this concept is essential for borrowers to avoid situations where their debt grows rather than diminishes.