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 that wouldn't even cover 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 the 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.
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.