Say you're applying for a $100,000 mortgage loan with a negative amortization feature that allows you to pay a significantly discounted monthly payment for the first year. Sounds great, right? Let's see how good it really is.

Understand first that any mortgage payment has two parts: payment of interest, and payment of principal (the actual amount of the loan). You obviously have to pay the interest or you don't get the loan. But the faster you can pay off principal, the faster you can burn the mortgage.

Start by imagining a conventional fixed-rate thirty-year loan of $100,000 at 6 percent, which would make your monthly payment roughly $600. Say the first month's payment breaks down so that $500 goes toward interest and $100 toward principal. That means after that first payment, you would owe $99,900. Now, because you've got a fixed rate, if you held on to that same mortgage for thirty years and paid no more than what was required every month, you would eventually see your interest payments diminish and your principal payments rise until the loan was fully paid in thirty years.

Now with the above loan in mind, let's look into the negative amortization world. Suppose the same lender says, “Let's amortize that $100,000 over the same thirty-year term, but hey, forget the $600 payment. I'm going to let you pay $400 since that's what you said you could afford.” Happily, you sign. But now you're not paying any principal, and you actually owe $100 more in interest in the first month alone, meaning that after your first month's payment your new loan balance is now $100,100; you have now borrowed an additional $100. When the payment doesn't cover the interest, that's negative amortization. Of course, many negative amortization loans carry the not-so-attractive feature of adjustable rates at the end of a two- or five-year term which can send a monthly payment skyward if rates rise.

Would you take on a loan where your balance was almost certain to go up rather than down despite your payments?

In two specific scenarios, a negative amortization loan can be beneficial, but you really have to know what you're doing.

The first scenario involves experienced real estate investors who understand their particular markets and properties so well that they can take on the risk of such loans because they know they'll be able to unload their investment on a specific timetable. The second involves individuals with a similarly superior knowledge of the market and solid finances who know they won't have any trouble selling or refinancing into a more stable loan product later.

Are there any guarantees for buyers in either of these two scenarios? Absolutely not. But that's the nature of risk. If you're going to take on a risky investment with an inherently risky loan product, you must have solid information about the future course of the market and a financial cushion to meet payments if the market turns cold or interest rates rise.

The words negative amortization got plenty of mileage in the post-2006 real estate slump, but there's nothing new about these loan products. Their best and only good use is as a short-term strategic loan product. A negative amortization loan is something no one could afford to hold for five years, much less for the thirty years most Americans agree to for a fixedrate home loan.

So, why wouldn't more risk-averse real estate professionals or homebuyers go with a thirty-year loan over a risky negative amortization loan? Because payment amounts on highly leveraged loans are generally significantly lower, at least initially, and that helps an investor's cash flow. Also, negative amortization loans often require less loan documentation from borrowers than their fixed-rate counterparts, which makes it easier for people to borrow who don't have a fixed income stream. Who would those be? Usually business owners and other professionals who may have higher incomes certain months and lower incomes in others.

Think of it this way. If you were an experienced real estate investor with a property in mind that you knew you could buy, fix up, and sell within a year, wouldn't you want your borrowing costs within that year to be as low as possible?

The bottom line is that negative amortization loans are for experienced real estate buyers and sellers who understand the market they're in, know exactly how much money they can afford to lose, and know just where their next deal is.

The problem with negative amortization is that its use migrated toward average consumers who didn't understand the terms of such loans or had such troubled finances that they could never afford this type of loan product over the long haul.

This became clear in the post-2006 real estate slowdown. The subprime lending crisis owed a lot to negative amortization loans that were structured for people who didn't understand the risks of putting nothing or very little down in exchange for the freedom of paying less than their interest costs on a month-to-month basis. What a stunner to look at a mortgage statement to find out that six months, a year, or two years in, you owed more than you originally borrowed!

Who to blame? First, there have always been predatory lenders who have fixed their sights on less-informed and often lower-income customers facing credit hurdles of their own. Then you have reputable lenders who jumped into the subprime arena because they wanted a piece of the action for the higher profits such loans would bring. But perhaps the greatest blame belongs to the borrowers themselves who jumped at easy credit without doing any homework first.

Remember option ARMs from Chapter 14? As mortgage rates began to climb from historic lows back in 2004, people who had chosen option ARMs and taken advantage of the lowest payment amounts allowed got a rude surprise when rates and their overall monthly payment amount started to rise. Unless they could get back to paying the highest amounts of interest and principal or refinance into a fixed loan, they found their payments were continuing to rise, and they were sliding farther and farther behind.

And here's a scary note: Some borrowers found out that the payment caps that kept their payments at a certain level had no relationship to the amount their overall interest could increase over a specific term. This meant that their payments did not cover all the interest due on the loan as rates increased. The payment cap, which was supposed to protect the borrower from up-ticks in monthly payments, actually hid the interest being added to the total loan amount.

The bottom line? Always ask a potential lender if the loan you're applying for can produce negative amortization and under which circumstances that could happen.

Negative amortization can make an appearance in many loan products that offer initial low-payment options to cash-strapped borrowers. The rest of this chapter will examine some of the leading loan varieties you might hear about.