Negative amortization only occurs in loans in which the periodic payment does not cover the amount of interest due for that loan period. The unpaid accrued interest is then capitalized monthly into the outstanding principal balance. The result of this is that the loan balance (or principal) increases by the amount of the unpaid interest on a monthly basis. The purpose of such a feature is most often for advanced cash management and/or more simply payment flexibility, but not to increase overall affordability.
Neg-Ams also have what is called a recast period, and the recast principal balance cap is in the U.S. based on Federal and State legislation. The recast period is usually 60 months (5 years). The recast principal balance cap (also known as the “neg am limit”) is usually up to a 25% increase of the amortized loan balance over the original loan amount. States and lenders can offer products with lesser recast periods and principal balance caps; but cannot issue loans that exceed their state and federal legislated requirements under penalty of law.
Due to the specificity of the reverse-mortgage concept and the limited context in which the term appears in practice, most United States authorities use the term “negative amortization” to denote those and only those loans in which the borrower pays throughout the lifetime of the loan but during and only during its early stages, known as the negative-amortization or “NegAm” period, makes what are in effect partial payments, namely payments lower than the amount of interest accrued during the payment term.
NegAM loans today are mostly straight adjustable rate mortgages (ARMs), meaning that they are fixed for a certain period and adjust every time that period has elapsed; e.g., one month fixed, adjusting every month. The NegAm loan, like all adjustable rate mortgages, is tied to a specific financial index which is used to determine the interest rate based on the current index and the margin (the markup the lender charges). Most NegAm loans today are tied to the Monthly Treasury Average, in keeping with the monthly adjustments of this loan. There are also Hybrid ARM loans in which there is a period of fixed payments for months or years, followed by an increased change cycle, such as six months fixed, then monthly adjustable.