What happens in a negative amortization situation?

In a negative amortization situation, the borrower is making payments that are not sufficient to cover the interest that accrues on the loan. As a result, the unpaid interest is added to the principal balance, causing it to increase over time instead of decreasing. This often occurs in loans where the initial monthly payments are temporarily low, often seen in adjustable-rate mortgages or other types of loans with interest-only options.

The key aspect of this scenario is that the monthly payments are lower than the total interest due, which leads to the negative amortization effect. Over time, this can lead to a significantly higher loan balance than the original amount borrowed, placing the borrower in a financially precarious situation. This can also hinder their ability to refinance or sell the property without facing a significant financial loss, as the amount owed may exceed the property value.