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What Is Deferred Interest?
Deferred interest is when interest payments on a loan are postponed for a specific period of time. You won’t pay any interest if you pay off the entire balance before this period ends, but if you don’t, interest charges, often backdated, start accruing.
Deferred interest is common in retail financing and credit cards and can also apply to mortgages, such as deferred interest or graduated-payment mortgages, sometimes involving negative amortization.
Key Takeaways
- Deferred interest loans postpone interest payments, but can become costly if not paid off before the interest-free period ends.
- Retailers and credit card companies often offer deferred interest as a way to attract consumers for big-ticket purchases.
- If a deferred interest balance isn’t paid off in time, interest is often backdated and charged on the original loan amount.
- Mortgages with deferred interest can result in an increasing loan principal, known as negative amortization.
- Deferred interest options can lead to significant increases in mortgage payments after initial low-payment periods.
How Deferred Interest Operates and Its Common Uses
Deferred interest options are usually provided by retailers on big-ticket items, such as furniture and home appliances. It makes it easier and more attractive for a consumer to buy these items than if they had to pay upfront in full or take out a loan with interest, increasing the cost of the purchase.
Deferred interest options usually last for a specific period of time where no interest is charged. Once this period is over and if the loan balance has not been paid, then interest charges start accruing, sometimes at very high rates. It’s important for a consumer to be aware of the deferred interest period as well as any fine print laying out the terms of the offer. They should also, of course, ensure that they can pay off the loan before the interest-free period is over. Retailers provide deferred or “no interest” items through their credit cards or in-house financing.
Deferred interest loans can also be offered on credit cards. Typically as a marketing scheme to lure in consumers to sign up for a card, credit card companies offer deferred interest or no interest credit cards. These credit cards function like deferred interest loans, offering no interest on the balance for a set period. Once that period is over, interest starts being charged on the remaining balance or any balance going forward. If you’re considering switching from your current card to one with with a deferred interest rate (or no interest rate), make sure it’s one of the best balance transfer cards currently available.
Typically, on deferred interest loans, if the balance is not fully paid off before the period ends, interest is backdated and charged on the entire, original balance, regardless of how much of the balance is left.
Mortgages that include deferred interest features work in a slightly different way. The amount of interest that is not paid on a mortgage’s monthly payment is then added to the principal balance of the loan. When a loan’s principal balance increases because of deferred interest, it is known as negative amortization. For example, payment option ARMs, a type of adjustable-rate mortgage, 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.
The Impact of Deferred Interest in Mortgage Financing
Before the mortgage crisis of 2008, programs such as payment option ARMs had low introductory payments for the first 2-3 years, which payments increased significantly afterwards. 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
- 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, deferred interest loans are recast, raising payments to pay off the loan in 25 years. The payment becomes so high that 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. Deferred interest mortgages typically increase the overall cost of a loan and can be a dangerous option.
The Bottom Line
Deferred interest lets borrowers postpone interest payments for a set period, but if the balance isn’t fully paid, interest can retroactively apply, often at high rates. This can lead to negative amortization and higher long-term costs, as seen with deferred interest mortgages that may even risk foreclosure.
Retailers and credit card companies use these loans to attract buyers, so understanding terms, deadlines, and risks is important in avoiding unexpected debt and financial strain.
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