What characterizes a negative amortization situation in an Option ARM?

In a negative amortization situation in an Option ARM (Adjustable Rate Mortgage), the loan balance increases despite payments being made. This typically occurs when the monthly payment is insufficient to cover the interest due on the loan. As a result, any unpaid interest is added to the principal balance, causing it to grow over time instead of decreasing. This can create significant financial challenges for borrowers, as they may find themselves owing more than they initially borrowed, even after making regular payments.

Understanding this concept is crucial for recognizing how certain types of adjustable-rate mortgages can affect borrowers' financial situations. The alternative options do not accurately depict the dynamics of negative amortization. For instance, payments exceeding the interest due would result in a decrease in the loan balance, while a static loan balance or an early payoff without penalties would not reflect the increasing debt scenario characteristic of negative amortization.