Key Takeaways
- A deferred interest mortgage allows borrowers to delay interest payments for a specified period, often resulting in lower initial payments.
- Interest in a deferred interest mortgage accumulates and is added to the loan balance, leading to increased long-term costs.
- These mortgages can lead to negative amortization, where the loan balance grows despite payments being made.
- Graduated payment loans, a type of deferred interest mortgage, begin with low payments, which increase over time as the borrower’s expected income also increases.
- While allowing initial affordability, deferred interest mortgages carry higher risks, including potential default or negative equity if not managed carefully.
Get personalized, AI-powered answers built on 27+ years of trusted expertise.
What Is a Deferred Interest Mortgage?
A deferred interest mortgage, or an interest-only mortgage, allows the borrower to delay making interest payments on the loan for a specified period of time. A deferred interest mortgage lowers your payments in the short term, but borrowers often pay more over the life of the loan. The deferred interest is added to the loan balance.
Deferred interest loans can benefit homebuyers who need a lower payment to qualify for a mortgage. But they come with risks, such as negative amortization. Discover the pros and cons of deferred interest mortgage loans and how they work to determine whether they’re the right financial product for you.
How a Deferred Interest Mortgage Works
Lenders can tailor mortgage loans to allow for deferred interest payments by adding those terms to the contract.
Deferred interest provisions can be complex for both the borrower and the mortgage lender since they require customization of the payment schedule. They can also be risky for the borrower.
Exploring Types of Deferred Interest Mortgages
Deferred interest mortgages can be structured in a variety of ways. Common types of deferred interest mortgages include deferred interest loans and graduated payment loans.
Overview of Deferred Interest Loans
Essentially, deferred interest mortgage loans allow borrowers to make payments that are less than the total payment they owe. Lenders can vary this provision in different ways, but they will usually require that the borrower make at least a minimum payment of a certain amount.
If a borrower chooses to make less than their full monthly payment, the reduced payment will go toward the loan’s principal and some interest. The unpaid interest is then added to the balance of the loan. This increases the amount of interest that the borrower will eventually have to pay. In addition, the unpaid interest will now start accruing interest, so that the borrower will have to pay interest on interest.
Deferring interest usually results in negative amortization, meaning that rather than decrease with each monthly payment, the borrower’s debt continues to grow. For that reason, these loans are sometimes referred to as negative amortization mortgages.
Unlike most credit cards, which allow for debt to build up with no fixed end point, deferred interest loans have a definitive maturity date that will require the borrower to make a lump-sum payment of any unpaid interest at that time. Some deferred interest mortgages provide options for obtaining an extension, such as through a loan modification or a scheduled recast.
Understanding Graduated Payment Loans
Graduated payment mortgages are fixed-rate loans that start out with low monthly payments that rise by a certain amount each year. In theory, they can help homeowners who expect their incomes to grow fast enough to keep up with the rising payments and who can not afford to buy a home otherwise.
However, the interest and principal that are deferred to make those lower payments possible can also result in negative amortization.
Advantages and Disadvantages of Deferred Interest Mortgages
A major advantage of deferred interest mortgages is that they can help borrowers, particularly first-time homebuyers, purchase a home with affordable mortgage payments.
However, these loans have a higher risk than traditional fixed-rate mortgages. First, the homeowner may be unable to afford the increased monthly payments or the significant lump-sum payment at the end of the mortgage.
If the borrower cannot afford the new monthly payment, they risk defaulting on the loan and losing their home to foreclosure. Defaulting on a mortgage can also cause damage to the borrower’s credit score.
Because of negative amortization, the homeowner may ultimately owe more on their mortgage than their home is worth. If they wish to sell the home, the money received from the sale might be less than the outstanding loan balance with their mortgage lender.
Tip
Deferred interest mortgages offer homebuyers lower monthly payments for a period, but they increase later on. If you can’t afford the higher payments, you risk defaulting on the loan and losing your home through foreclosure.
Do Banks Still Offer Interest-Only Loans?
Banks do not often offer interest-only mortgages because of the risks. With an interest-only mortgage, a borrower pays a small monthly payment of only interest or partial interest for a set period of time. Later in the mortgage term, your payments and interest rate can rise, potentially leading to borrowers being unable to afford the monthly payments.
What Is the Difference Between Deferment and Forbearance?
A forbearance is when you and your lender pause your monthly payments required by your loan terms. A deferment is when you move your payment obligations to the end of your loan term, extending it and maintaining the same obligations for repayment. A deferment can be used to bring a loan that is in forbearance current.
Do You Pay Interest on Deferred Mortgage Payments?
When you modify your loan to include deferred mortgage payments, you likely won’t pay extra interest on the deferred payments. You will still be obligated to pay the interest you agreed to in your original loan terms.
The Bottom Line
A deferred interest mortgage allows a borrower to postpone paying the loan’s interest for a period, creating lower payments early on. However, the payments eventually increase, and interest accrues and is added to the outstanding loan balance. As a result, deferring interest can cause negative amortization, meaning your debt increases even as you make payments.