Interest Shortfall

An interest shortfall is the accrued interest that remains due after the borrower has made their monthly payment.

Interest shortfalls are a feature of adjustable-rate mortgages, in which the interest rate applied to the outstanding balance varies throughout the life of the loan. When rate caps limit monthly loan payments, the homeowner’s payments may be less than the interest due. This unpaid interest increases the outstanding principal balance of the loan, which is called negative amortization.

While negative amortization protects borrowers from payment shock associated with an increase in the ARM interest rate, it will take longer to fully amortize the loan. If interest rates continue rising, the equity in the home will decline rather than rise, unless the price of the house rises. Most mortgages have limits on interest shortfall, to protect both borrower and lender.

In the mortgage backed security market, interest shortfalls occur when the interest distributed is less than the amount of interest accrued as a result of mortgage prepayments. Interest shortfalls occur when fees and expenses associated with troubled loans reduce the amount of interest available to be paid on a mortgage backed security. If there’s an interest shortfall, interest is deferred, with subordinate classes usually the first to be affected.