What is a 'Deferred Interest'

Deferred interest is the amount of interest added to the principal balance of a loan when the contractual terms of the loan allow for a scheduled payment to be made that is less than the interest due. When a loan's principal balance increases because of deferred interest, it is known as negative amortization. For example, adjustable-rate mortgages, known as payment option ARMs, and fixed-rate mortgages with a deferrable interest feature carry the risk of the monthly payments increasing substantially at some point over the term of the mortgage.

BREAKING DOWN 'Deferred Interest'

Deferred interest is interest that has accrued on a loan but has not been paid. The interest accumulates when a loan payment is not large enough for covering all the interest due.

History of Deferred Interest

Before the mortgage crisis of 2008, programs such as payment option ARMs let borrowers choose their monthly payment. Mortgagors could choose a 30-year or 15-year payment, an interest-only payment covering interest but not reducing the principal balance, or a minimum payment not even covering the interest due. The difference between the minimum payment and the interest due was the deferred interest, or negative amortization, which was added to the loan balance.

For example, say a mortgagor received a $100,000 payment option ARM at a 6% interest rate. The borrower could choose from four monthly payment 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; or a minimum payment of $321.64. Making the minimum payment means deferred interest of $178.36 is added to the loan balance monthly. After five years, the loan balance with deferred interest is recast, meaning the required payment increases enough to pay off the loan in 25 years. The payment becomes so high, the mortgagor cannot repay the loan and ends up in foreclosure. This is one reason why loans with deferred interest are banned in some states and considered predatory by the federal government.

Negative Amortization

With a deferred interest mortgage or payment option ARM, the mortgagor may have a payment cap and the interest rate may increase. Because the difference is added to the balance, rather than lowering the amount owed on a loan, the debt increases.

This may be a challenging situation, especially if the mortgagor wants to sell the home. Deferred interest may result in a borrower being upside-down in a mortgage, meaning he owes more than he may receive from selling the home.

RELATED TERMS
  1. Negatively Amortizing Loan

    A loan with a payment structure that allows for a scheduled payment ...
  2. Negative Amortization

    An increase in the principal balance of a loan caused by making ...
  3. Deferred Interest Mortgage

    A mortgage loan that allows the borrower to make minimum payments ...
  4. Fully Amortizing Payment

    A periodic loan payment, part of which is principal and part ...
  5. Amortized Loan

    A loan with scheduled periodic payments of both principal and ...
  6. Option Adjustable-Rate Mortgage ...

    A type of mortgage where the mortgagor (borrower) has several ...
Related Articles
  1. Personal Finance

    Option ARMs: American Dream Or Mortgage Nightmare?

    Option adjustable rate mortgages could make or break your home-buying experience.
  2. Personal Finance

    What is an Amortization Schedule?

    An amortization schedule is a table that shows the amounts of principal and interest that comprise each loan payment.
  3. Personal Finance

    Choose Your Monthly Mortgage Payments

    Exotic mortgages allow you to decide how much to pay. Find out how much they really cost.
  4. Personal Finance

    How Interest Rates Work On A Mortgage

    A step-by-step explanation of the interest calculations, mortgage types, and how the loan is eventually "retired" – which means paid off.
  5. Personal Finance

    Mortgage Amortization Strategies

    Should you get a 30-year mortgage? A 15-year one? Ways to decide which mortgage is the best fit.
  6. Personal Finance

    Understanding the Mortgage Payment Structure

    We explain the calculation and payment process as well as the amortization schedule of home loans.
  7. Personal Finance

    Simple Interest Loans: Do They Exist?

    Yes, they do. Here is what they are – and how to use them to your advantage.
  8. Personal Finance

    Mortgages: Fixed-Rate Versus Adjustable-Rate

    Both of these have advantages and disadvantages depending on your financial needs and prospects.
  9. Personal Finance

    This ARM Has Teeth

    Find out how to avoid getting bitten when your mortgage rate resets.
RELATED FAQS
  1. Are student loans amortized?

    Student loans typically get paid back over time on a fixed payment, or amortized, schedule. Read Answer >>
  2. When capitalizing interest, will interest accrue while you are in a deferment?

    Learn what capitalized interest is. Understand why interest accrues while a person is in a deferment, based on capitalized ... Read Answer >>
  3. Can Direct Consolidation Loans be deferred?

    Student loans bundled into direct consolidation loans may be deferred under certain circumstances. Read Answer >>
  4. Why is more interest paid over the life of a loan when it is capitalized?

    Learn what it means to capitalize interest on a loan. Understand why more interest is paid over the life of a loan when it ... Read Answer >>
  5. Which is better, a fixed or variable rate loan?

    A variable interest rate loan is a loan in which the interest rate charged on the outstanding balance varies as market interest ... Read Answer >>
  6. What's the difference between a grace period and a deferment?

    Learn the difference between grace periods and deferments and when each type of delayed-payment period applies to various ... Read Answer >>
Trading Center