Final answer:
Negative amortization is when loan payments are too low to cover the interest, causing the unpaid interest to be added to the principal. This can increase the total debt. Understanding your payment capacity and interest rates' effect on loan value is crucial for financial health.
Step-by-step explanation:
What best describes negative amortization? The correct answer is A: Payments that are insufficient to pay interest, the difference is added to the principal. Negative amortization occurs when the payments made by a borrower are not large enough to cover the interest on a loan, resulting in the unpaid interest being added to the loan's principal balance. This can lead to an increase in the total amount owed because the loan interest is now calculated on the increased principal.
It is important to know how much you can afford to pay each period and calculate a maximum loan amount to avoid such scenarios. Making payments greater than the minimum can save money on interest, as demonstrated in Example C. This strategy can prevent the cost of a loan, such as a 30-year mortgage, from more than doubling.
Factors such as a borrower's history of late payments, changes in general interest rates, or a borrower's profitability can influence the attractiveness of a loan, as discussed in Points 6 and 7. An increase in the amount of available loanable funds typically leads to a decrease in interest rates, as lenders compete to provide loans.