Question 71

Negative amortization occurs when payment is less than accrued interest.

Negative amortization takes place when the payments made on a loan are lower than the interest that accumulates on the principal balance. This results in the outstanding balance of the loan increasing over time, rather than decreasing.

A) ARM margin is increased

This option is incorrect because increasing the adjustable-rate mortgage (ARM) margin does not directly relate to negative amortization. The ARM margin affects the interest rate calculation but does not determine whether payments cover the accrued interest.

B) payment is interest-only

While interest-only payments can lead to a situation where the principal balance does not decrease, they do not necessarily result in negative amortization unless the payment is specifically less than the interest accrued. Therefore, this option does not accurately define negative amortization.

C) payment is less than accrued interest

This option correctly identifies the definition of negative amortization. When the payment made is less than the interest that accrues during the period, the unpaid interest is added to the principal balance, leading to negative amortization.

D) index is adjusted

This option is incorrect as well. Adjusting the index in an ARM can affect the interest rate, but it does not directly cause negative amortization. Negative amortization specifically relates to the payment amount in relation to accrued interest.

Conclusion

The correct answer is C, as it precisely defines negative amortization by highlighting the relationship between payments and accrued interest. Options A, B, and D fail to capture this essential aspect, while only C accurately describes the condition under which negative amortization occurs. Understanding this concept is vital for managing loans effectively and avoiding the pitfalls of increasing debt.