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Do You Understand the Three Types Of Loans - Conventional, Interest-Only, and Negative Amortization?

Published by Lawrence Roberts | December 26th 2008 | Views:

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There are 3 main categories of loans: Conventional, Interest-Only, and Negative Amortization. The distinction between these loans is how the amount of principal is impacted by monthly payments. Conventional loans pay off the debt, interest only loans neither increases or decreases the debt, and negative amortization loans add to the debt.

A Conventional mortgage includes some amount of principal in the payment in order to repay the original loan amount. The greater the amount of principal repaid, the quicker the loan is paid off. This kind of mortgage has an amortization schedule that determines how fast the loan is paid back. A 30-year term is the most common.

An Interest-Only loan does just what it describes; it only pays the interest. This loan does not pay back any of the principal, but it at least "treads water" and does not fall behind. At some point, an interest-only loan converts to a conventionally amortized loan and the balance is repaid.

The Negative Amortization loan is one in which the full amount interest is not paid with each payment, and the unpaid interest gets added to the principal balance. Each month, the borrower is increasing the debt. These loans are inherently unstable, and most who used them ended up in foreclosure.

Two of the features of all Interest-Only or Negative Amortization loans are an interest rate reset and a payment recast. All these loans have provisions where the interest rate changes or loan balance comes due either in the form of a balloon payment or an accelerated amortization schedule. In any case, borrowers often must refinance or face a major increase in their monthly loan payment. This increase in payment is what makes these loans such a problem.

The Great Housing Bubble was inflated by exotic loan terms, in particular by negative amortization loans. As loan holders defaulted in large numbers, these loan programs were curtailed or eliminated. The withdrawal of financing deflated the housing bubble.
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