Understanding Deferred Interest Mortgages: How They Work and What You Need to Know

Julia Kagan is a financial and consumer journalist with extensive expertise in personal finance and mortgage topics.

What Is a Deferred Interest Mortgage?

A deferred interest mortgage, often called an interest-only mortgage, lets borrowers postpone paying some or all of the interest on their loan for a certain period. This results in lower monthly payments at the start but can lead to higher overall costs because the unpaid interest is added to the loan balance.

This type of mortgage can be helpful for buyers needing lower initial payments to qualify, but it carries risks that should be carefully considered.

Key Points to Remember

• Deferred interest mortgages allow deferral of interest payments temporarily.
• Interest continues to accumulate and is added to the principal, increasing the loan balance.
• This can cause negative amortization, where the debt grows despite payments.

How Does a Deferred Interest Mortgage Work?

Lenders customize mortgage contracts to include deferred interest terms, adjusting payment schedules accordingly. These arrangements can be complex and risky for borrowers if not fully understood.

Types of Deferred Interest Mortgages

Common variations include deferred interest loans and graduated payment loans.

Deferred Interest Loans

Borrowers make payments lower than the full amount due, with unpaid interest added to the loan principal and accruing additional interest. This often leads to increasing debt, known as negative amortization. Unlike credit cards, these loans have a fixed maturity date requiring repayment of all deferred interest.

Note

Flexible payment adjustable-rate mortgages (option ARMs), which allowed interest deferral, were largely discontinued in 2014 due to regulatory changes addressing their risks.

Graduated Payment Loans

These fixed-rate mortgages start with low payments that increase annually, designed for borrowers expecting income growth. However, deferred principal and interest can also cause negative amortization.

Pros and Cons of Deferred Interest Mortgages

Advantages include lower initial payments that can help first-time buyers enter the market. However, risks include potential inability to afford higher future payments or lump-sum balances, leading to default or foreclosure.

Negative amortization may result in owing more than the home's value, complicating resale.

Important Tip

While deferred interest mortgages offer short-term payment relief, be sure you can handle increased payments later to avoid financial hardship.

Are Interest-Only Loans Still Offered by Banks?

Due to their risks, interest-only mortgages are less common today. These loans feature low initial payments that can rise significantly, posing affordability challenges.

Deferment vs. Forbearance

Forbearance pauses loan payments temporarily, while deferment postpones payments to the loan's end, extending the term but maintaining repayment obligations.

Do You Pay Interest on Deferred Payments?

Typically, deferred payments do not incur extra interest beyond the original loan agreement, but interest continues to accrue on the outstanding balance.

Final Thoughts

Deferred interest mortgages provide early payment flexibility but can increase total debt due to accrued interest and negative amortization. Understanding these dynamics is crucial before choosing this mortgage type.

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