When you get a loan, typically you will make monthly payments to pay off the amount you borrowed. Included in your monthly payments is an amount of money that represents interest. Month by month and year by year, your balance on the loan decreases. However, in some cases, the lender may defer the interest, meaning you make a payment that is less than the total amount due. This results in a lower payment, but at some point in the future, you will still owe the additional interest.
Definition of Deferred Interest
Deferred interest is interest that has accrued but not been paid. Mortgage interest is paid in arrears, which means the borrower does not pay it in advance. Mortgage payments cover interest that is already owed to the lender. “Deferred interest” accumulates when a loan payment is not large enough to cover all the interest due.
Deferred Interest for a Mortgage Loan Explained
There are, however, cases in which your outstanding debt does not decrease. One such case is called deferred interest or negative amortization. This can happen if you have a deferred interest mortgage. Or this can occur if you have an adjustable rate mortgage, or ARM, and you have a payment cap but your interest rate increases. The difference can be added to your balance, so with deferred interest, instead of lowering the amount you owe on a loan, your debt increases.
This can be a sticky situation, especially if you want to sell your home. Deferred interest can result in being upside-down in your mortgage, which means that you owe more than you can get for the house. On the other hand, a deferred interest mortgage is not always a negative thing. For instance, if you expect to have a substantial salary increase within a few years, deferred interest can work for you. The idea is that once you get your salary increase, you will make enough to cover the higher payments over the life of the loan.
It is essential for you to understand loans and mortgages so that you can know what to expect for your finances after you sign your papers. Be sure to research different kinds of loan and mortgage products so that you can make a financial plan that you can manage. It is also a good idea to keep your eye on interest rates so that if you get an adjustable rate loan, you know whether your interest rates are comparatively high or low.
History of Deferred Interest on Homes
Before the mortgage crisis in 2008, mortgage programs called “payment option ARMs” allowed borrowers to choose their payment every month. They could choose a 30-year mortgage payment, a 15-year mortgage payment, an interest-only payment, which would cover the interest due but not reduce the principal balance, or a minimum payment, which would not even cover the interest due. The difference between the minimum payment and the interest due was called “deferred interest” or “negative amortization” and added to the loan balance.
For example, if a borrower took a $100,000 payment option ARM at a 6.00 percent rate, he or she could choose a payment every month from four options:
A fully-amortizing 30-year fixed payment of $599.55
A fully-amortizing 15-year payment of $843.86
An interest-only payment of $500.00
A minimum payment of $321.64
Making the minimum payment would cause deferred interest of $178.36 to be added to the loan balance. After five years, the loan could be re-cast, which meant taking the loan balance including the deferred interest and changing the required payment to one large enough to pay the loan off completely in 25 years. Often, the payment was so much higher that the borrowers could not repay their loans and ended up in foreclosure. This is why loans with deferred interest have been banned in some states and are considered “predatory” by the federal government.
Deferred Interest on Credit Cards
Deferred interest on credit cards and other loans may allow you to make purchases without paying interest. Here's how it works. Essentially, you make a purchase on your credit card. Your deferred interest will last a certain number of months (per your credit card company); let's say 12 months. So for 12 months, you pay no interest. In most cases, if you fully pay off the amount you owe within this time, then no interest is accrued--you essentially get 12 months to pay off a major purchase. The problem occurs if you don't pay off the full amount. At the 12 month mark, all the past interest accrues, meaning that you now owe the interest from that last 12 months. This can greatly increase the amount you owe, and lock you into paying a lot of interest if you can't keep up with the new payment amount.