In the context of notes payable, negative amortization describes a loan balance that:

• A. Increases over time because the periodic payment is less than the interest expense for the period (unpaid interest is added to principal).
• B. Remains constant over time because each payment equals the interest accrued for the period.
• C. Decreases over time because each payment includes enough interest and some principal reduction.
• D. Decreases only when a balloon payment is made at maturity, with no interest accruing during the term.

Answer: (A)

Verified step by step guidance

1. Understand the concept of notes payable and how amortization affects the loan balance over time. Amortization refers to the process of paying off a loan through regular payments that cover both interest and principal.
2. Recognize that in normal amortization, each payment covers the interest expense for the period plus some portion of the principal, which causes the loan balance to decrease over time.
3. Define negative amortization: it occurs when the periodic payment is less than the interest expense for the period. This means the unpaid interest is not paid off but instead added to the principal balance, causing the loan balance to increase.
4. Express this relationship mathematically: if \(P\) is the principal balance, \(i\) is the interest rate per period, and \(PMT\) is the payment amount, then negative amortization happens when \(PMT < P \times i\). The unpaid interest is \(P \times i - PMT\), which is added to the principal.
5. Conclude that under negative amortization, the loan balance grows over time because the unpaid interest accumulates, increasing the principal amount owed.