Deferred Interest Mortgage: What it Means, How it Works, Types (2024)

Deferred interest mortgages can offer homebuyers the advantage of lower monthly payments for a set amount of time. However, these loans also carry risks because the monthly payments increase. So, if you can't afford the higher payments, you would risk defaulting on the loan and potentially losing your home.

What Is a Deferred Interest Mortgage?

A deferred interest mortgage, or an interest-only mortgage, is a mortgage that allows the borrower to delay making interest payments on the loan for a specified period of time.

This type of mortgage can mean lower payments in the short term, but borrowers often pay more in total costs over the life of the loan. Deferred interest loans can benefit some homebuyers, but they have risks to consider.

How a Deferred Interest Mortgage Works

Lenders can tailor mortgage loans to allow for deferred interest payments by adding those terms to the contract.

Deferred interest provisions can be complex for both the borrower and the lender since they require customization of the payment schedule. They can also be risky for the borrower.

Types of Deferred Interest Mortgages

Deferred interest mortgages can be structured in a variety of ways. Common types of deferred interest mortgages include deferred interest loans and graduated payment loans.

Deferred Interest Loans

Essentially, deferred interest mortgage loans allow borrowers to make payments that are less than the total payment they owe. Lenders can vary this provision in different ways, but they will usually require that the borrower make at least a minimum payment of a certain amount.

If a borrower chooses to make less than their full monthly payment, the reduced payment will go toward the loan’s principal and some interest. The unpaid interest is then added to the balance of the loan. This increases the amount of interest that the borrower will eventually have to pay. In addition, the unpaid interest will now start accruing interest, so that the borrower will have to pay interest on interest.

Deferring interest usually results in negative amortization, meaning that rather than decrease with each monthly payment, the borrower’s debt continues to grow. For that reason, these loans are sometimes referred to as negative amortization mortgages.

Unlike most credit cards, which allow for debt to build up with no fixed end point, deferred interest loans have a definitive maturity date that will require the borrower to make a lump-sum payment of any unpaid interest at that time. Some deferred interest mortgages provide options for obtaining an extension, such as through a loan modification.

Graduated Payment Loans

Graduated payment mortgages are fixed-rate loans that start out with low monthly payments that rise by a certain amount each year. In theory, they can help homeowners who expect their incomes to grow fast enough to keep up with the rising payments and who can not afford to buy a home otherwise.

However, the interest and principal that are deferred to make those lower payments possible can also result in negative amortization.

Pros and Cons of Deferred Interest Mortgages

Deferred interest mortgages can help some homeowners, particularly first-timers, obtain homes with affordable mortgage payments at the outset. That is their major advantage.

However, these loans have higher risk than traditional fixed-rate mortgages. First, the homeowner may not be able to afford the increased monthly payments or significant lump-sump payment at the end of the mortgage.

If the borrower cannot afford the new monthly payment amount, they risk defaulting on the loan and losing their home to foreclosure. Defaulting on a mortgage can also cause damage to the borrower’s credit score.

Because of negative amortization, the homeowner may ultimately owe more on their mortgage than their home is worth. If they wish to sell the home, they may find that the money they could receive from the sale is less than they need to repay their lender.