What Is a Deferred Interest Mortgage?

A deferred interest mortgage is a mortgage that allows for the deferral of some or all of the interest required on the loan. A deferred interest mortgage allows the borrower to postpone the interest payments on the loan for a specified time. It enables borrowers to initially make minimum payments on the loan that are less than the standard payment amount. There are various types of deferred interest mortgages including incremental deferred interest mortgages and payment-option adjustable-rate mortgages (ARM).

Key Takeaways

  • A deferred interest mortgage allows borrowers to defer paying some or all of a loan's interest for a specified time.
  • An incremental deferred interest mortgage allows borrowers to make minimum payments that are lower than the total payment owed, which means interest will accrue and will be added to the total loan balance.
  • Lenders can offer borrowers a payment-option adjustable-rate mortgage, which allows borrowers to choose from various payment options each month when payment is due.
  • A balloon payment loan is a type of deferred interest mortgage where the borrower makes no principal or interest payments until the loan's maturity date, at which time the borrower is required to pay off the loan in a lump sum that includes both principal and interest.

How a Deferred Interest Mortgage Works

Deferred interest mortgage terms can be integrated to customize all types of mortgage loans. In the mortgage market, deferred interest is most commonly associated with balloon payment loans and payment-option adjustable-rate mortgage (ARM) loans. Deferred interest provisions can be complex for both the borrower and the lender since they require customization to the payment schedule.

Incremental Deferred Interest Mortgage

Generally, incremental deferred interest mortgage loans allow a borrower to make minimum payments that are less than the total payment owed. Lenders can vary this provision in different ways but will usually have a minimum payment that can be allowed for the borrower below the standard payment amount.

If a borrower chooses to exercise their deferred interest rights and pay the lower balance, then the payment will cover the principal and some interest. The excess interest is then added to the total balance of the loan. This increases the amount of interest charged on future payments.

Incremental deferred interest is usually synonymous with negative amortization. With incremental deferred interest, a homeowner lets interest accrue, ultimately increasing the total cost of the loan. Different from deferred interest credit card debt, deferred interest loans have a definitive maturity and will require a borrower to make a lump sum payoff when the loan reaches maturity. There can be some considerations for deferred interest mortgages that will allow for an extension, such as loan modification or forbearance.

Although negative amortization can help borrowers afford their monthly payments in the short term, it can also subject borrowers to payment shock should interest rates jump higher in the future.

Payment Option Adjustable Rate Mortgages

In the mortgage market, lenders can offer borrowers a payment-option adjustable-rate mortgage. This type of product is one of the most common loans where negative amortization will occur.

In an adjustable-rate mortgage, borrowers pay both a fixed rate and a variable rate of interest. Payment options will likely start with a low fixed interest rate for a short period of time. Once the borrower reaches a specified reset date, they will then have several options on the type of payment they would like to make in the variable rate portion of the loan.

The borrower might make the minimum fixed interest payment. They may also have the option to pay only interest. They can also pay the standard variable rate that is required or they may also have other options determined by the lender. In all scenarios except for the standard loan payment, the borrower will incur deferred interest since the payment is below the standard amount. The excess balance is then added to the outstanding balance.

In a payment-option ARM, the borrower has various options at each payment time. They may choose to make the minimum payment in one month followed by a higher payment in the following month. Payment option ARMs were designed to help borrowers with volatile income levels since borrowers can choose from any payment option at each month when the payment is required.

Balloon Payment Loans

Balloon payment loans are a standard type of deferred interest mortgage. With a balloon payment loan, the borrower makes no payments on principal or interest throughout the entire life of the loan. The borrower is required to pay off the loan in a lump sum that includes both principal and interest at the loan’s maturity date.

Generally, in balloon payment loans for longer than one year, lenders will structure the interest to accrue and defer annually. Lenders have the option to accrue interest on any schedule they specify in the loan terms.