Final answer:
The condition where a mortgage payment doesn't cover the interest, leading to an increase in the principal balance, is called negative amortization. It occurs in loan structures with initially low payments and can result in a higher risk for both lender and borrower.
Step-by-step explanation:
When a borrower's mortgage payment is insufficient to cover the interest for that month, the result is known as negative amortization. This situation arises when the loan structure allows for lower payments in the initial term, with the unpaid interest being added to the principal balance. As a result, instead of paying down the loan, the borrower's balance increases over time.
It's important to consider the potential consequences of negative amortization. As the principal balance grows, the borrower might find themselves owing more than the original loan amount, and in extreme cases, more than the value of the property itself.
This financial situation can lead to difficulty in refinancing and can pose a risk to both the lender and borrower, similar to issues faced when interest rates rise, making the loan less appealing.
Lenders view borrowers with a history of late payments as higher risk, which affects the desirability and value of the loan. If a borrower has frequently been late on payments, they appear less likely to repay the loan on time, and an investor would likely pay less for such a loan.
Additionally, if interest rates have increased since the loan was made, a fixed-rate loan at a lower interest rate would be less attractive compared to the current higher rates available in the market, thus reducing its sale value.