What financial situation may arise if monthly payments do not cover actual interest rates?

When monthly payments do not cover the actual interest rates on a loan, negative amortization occurs. This situation arises when the borrower pays less than the interest that accrues on the loan, leading to an increase in the total loan balance over time. Instead of paying down the principal, the borrower finds themselves with a growing debt because the unpaid interest is added to the principal amount originally borrowed.

Negative amortization can happen in certain types of loans, such as adjustable-rate mortgages or loans with payment plans that allow for lower initial payments. The borrower may initially benefit from lower monthly payments but could face significant financial strain in the long run as the loan balance increases. This can create a cycle of debt that is challenging to manage, potentially leading to more severe outcomes, such as foreclosure or loan default, if the borrower cannot meet their obligations. Understanding negative amortization is crucial for borrowers to make informed decisions about loan structures and repayment plans.