What Is a Deferred Interest Mortgage?

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DEFINITION
Deferred interest mortgages are mortgages that allow borrowers to pay less in interest earlier in the loan.

Deferred interest mortgages are mortgages that allow borrowers to pay less in interest earlier in the loan. Then, they make larger payments or one large payment, known as a balloon payment, to complete their mortgage’s payment schedule.

You may consider a deferred interest mortgage if you want a lower payment at the start of a loan and a larger payment later on. Let’s learn more about the benefits and risks of these mortgage structures.

Definition and Examples of Deferred Interest Mortgages

Deferred interest mortgages are mortgages that offer lower interest payments at the beginning of a loan, with loan payments either increasing over time or due later in one lump sum. When these deferred interest amounts are due and how much interest payments increase depend on the loan’s terms.

  • Alternate names: Balloon payment mortgage, payment-option adjustable-rate mortgage, graduated-payment mortgage

Lenders offer a variety of payment schedules that can help borrowers qualify for lower payments on a mortgage, provided the borrower meets the criteria.

For example, a balloon payment loan offers lower payments the first few years, then requires a large payment later in the loan or at the end of the loan term. This lump-sum payment makes up for the interest cost that you saved at the start.

While you have more time to save for the payment, a balloon payment loan could result in you paying more in total interest. Because the interest is deferred and added to the principal of the loan, the interest then accrues more interest over time.

There are other types of deferred interest mortgages, as well, like the payment-option adjustable-rate mortgage (ARM). Interest on an ARM changes according to the interest of a benchmark index. Among this plan’s payment “options,” the borrower will usually find a deferred interest plan in which payments cover less interest than you owe. The remaining interest is added to your principal.

Example of Deferred Interest Mortgage

To illustrate, consider someone who wants to buy a $300,000 home. They have a tight monthly budget, but they believe they are on a good career track and will likely increase their income. A traditional 30-year loan with a fixed 3.42% interest rate on that home would require a monthly principal and interest payment of about $1,067.

To reduce this payment, the buyer may consider a deferred interest loan that lowers their monthly principal and interest payment to, say, $800 for a certain period of time. Payments would then slowly increase over time to compensate for the total interest deferred.

Or, in that same scenario, a balloon payment deferred interest loan might give the buyer $800 monthly payments with the stipulation that they’ll have a lump sum due later. For example, they may have to make a $10,000 or $20,000 balloon payment after 10 or 20 years of the loan. The actual amount and timing of a balloon payment will depend on the specific loan terms.

Balloon payment mortgages can be risky and are not allowed with qualified loans. Consider what you would do if you could not afford the balloon payment, nor could you resell or refinance before it’s due. If you don’t think you can manage the larger payment, consider another type of mortgage.

How Does a Deferred Interest Mortgage Work?

A deferred interest mortgage can be structured in a few different ways, but the general principle of delaying interest payments is the same. Any interest that isn’t paid earlier in the mortgage is added to the total principal of the loan and paid off through larger payments later.

Deferring interest can result in a few months or even years of what is called negative amortization. This means that, for some amount of time, you could owe more on the house than it is worth on the market. Negative amortization is risky because, if you cannot make your payments or sell the home, you could face foreclosure.

Negative amortization loans are more expensive in the long run. Borrowers should consider them carefully and weigh them against other options, like continuing to rent and save for a traditional fixed-rate mortgage.

Types of Deferred Interest Mortgages

One form of deferred interest mortgage is the balloon payment mortgage. This mortgage offers lower monthly payments with a larger payment due later. The risk of these loans is that your financial situation may not improve to support the payment of your balloon when it’s due.

Other deferred payment options are the graduated-payment mortgage, a type of loan in which payments steadily increase. You’ll need to plan for how you’ll make these payments when they increase.

A payment-option ARM is a loan product that lets you choose how your payment will be structured, such as:

  • A reduced-interest payment with the remaining interest due added to your principal
  • An interest-only payment
  • A traditional principal and interest payment

Are Deferred Interest Mortgages Worth It?

A deferred interest mortgage makes sense for some borrowers, depending on their financial situation. If you feel it is an ideal time for you to buy a home, and you have a tight budget but expect your income to increase, you might want to consider a deferred interest loan.

However, these loans do carry risks, including the potential that you won’t be able to make higher payments later. Borrowers who can afford to pay full payments on a traditional mortgage can save more in the long run.

Key Takeaways

  • Deferred interest mortgages give borrowers a lower payment upfront with higher payments later, and the overall interest costs increase.
  • These types of mortgages are often negative amortization loans, meaning the total principal due is higher than the market value of the home at the beginning of the loan.
  • A deferred interest mortgage is considered riskier than a typical mortgage because borrowers risk not having additional funds needed for higher payments in the future.

Article Sources

  1. FDIC. Interest-Only Mortgage Payments and Payment-Option ARMs,” Page 11. Accessed Dec. 6, 2021.

  2. Consumer Financial Protection Bureau. “What Is a Balloon Payment? When Is One Allowed?” Accessed Dec. 6, 2021.

  3. Consumer Financial Protection Bureau. “What Is an Option or Payment-Option ARM?” Accessed Dec. 6, 2021.

  4. Consumer Financial Protection Bureau. “What Is Negative Amortization?” Accessed Dec. 6, 2021.

  5. FDIC. “Interest-Only Mortgage Payments and Payment-Option ARMs,” Page 14. Accessed Dec. 6, 2021.