Deferred interest on a loan isn’t as great as it sounds and could end up costing you a lot of money
Deferred interest loans are a type of loan with deferred interest, which is when the interest due on the loan is not paid until sometime in the future. The main purpose behind these types of loans is to allow people to use money without having to pay interest. These types of loans can be thought of as a type of “interest free loan”, which allows people to be able to get more purchasing power than they would have if they had merely saved the money that they didn't have beforehand.
If you've ever taken out a student loan, then you probably know what it's like being at least somewhat familiar with deferred interest payments. If you notice your monthly payment includes some money towards paying off your debt, but doesn't show up later on as payments towards the interest accrued on your loan, you know that you are paying deferred interest.
This is the main thing that separates deferred interest loans from normal loans… However, there are a lot of differences between deferred interest loans and student loans. Student loans typically have very small amounts of interest each month, so it is perfectly suited for making the payments towards paying off your debt while still having enough money to use for your comfortability and convenience.
Another important difference to think about when you're trying to compare deferred interest student loans with other kinds of deferred interest loans is that student loan deferments only last for a limited amount of time, whereas with other types of deferred interest mortgages or auto loans you will be required to make monthly payments for a pretty long period of time (usually around 30 years) before you fully pay off the loan… So if you're wondering why you might want to consider a deferred interest loan over a normal one, it's because of the fact that you can avoid making monthly payments for almost an entire decade before any interest is due.
With interest rates and home prices creeping higher, I’ve started to see the return of a deferred interest and other deferred programs in loans. It’s something that became very common before the housing bubble burst so I wanted to get some information…and my opinion out.
Deferred interest is a poisonous snake waiting to strike from a wrapped gift with a bow on top.
How’s that for a visual metaphor?
A lot of people think deferred interest on a loan is a saving grace when they get approved but find out later that it caused more problems than it solved.
Understand what deferred interest means and all the consequences before you decide to go down that road.
What is Deferred Interest?
Some loans will allow you to make a payment less than the scheduled amount, usually over an initial period or if you run into trouble paying your loan back. Deferred interest is the amount of unpaid interest that is added back to the loan amount.
If your normal loan payment is $350 but you only pay $275 then the $75 difference is added back to your loan as deferred interest.
It’s also called negative amortization. That word sounds a lot scarier and denotes the true risk in deferred interest, which is why bankers and lenders don’t use it.
Amortization is the schedule of paying off your loan, how much is paid off from principal every month and how much remains to be paid. If you have ‘negative’ amortization then the loan amount is getting bigger rather than being paid off.
Deferred interest may sound great at first, being able to pay less than the scheduled amount on the loan, but there are some serious consequences that most people don’t realize.
- The amount you owe increases and your scheduled payment amount will increase if you are to pay off the loan in the same amount of time.
- Your loan payment might not increase if the lender is willing to extend the payoff date but you’ll still end up paying more in interest. Anything added back to the loan, that deferred interest, will start charging interest as well.
- If the loan payoff date is not extended and the monthly payments aren’t increased, you’ll have a big balloon payment to make at the end of the loan…forcing you to scramble to find the money.
Deferred Interest Example
I put together an example to see just how bad deferred interest can get. The graphic below shows three scenarios on a $200,000 mortgage loan for 30 years. The original loan schedules a payment for $1,043 per month to pay the mortgage completely over the 360 months.
Now imagine two scenarios where deferred interest was taken for two years. No payments were made on the loan and interest is added back.
In the first scenario, the monthly payment is recalculated so the loan is still paid off over the original period. In this scenario, the monthly payments jump by more than $140 a month just to pay the loan off.
Possibly worse is the third scenario where the payments do not change but the borrower is required to pay a lump sum ‘balloon payment’ at the end of the 360 months. In this scenario, you would need to come up with nearly $100,000 to pay off the loan…
Happen to have $100,000 in the bank?
How Does Deferred Interest Affect My Mortgage Loan?
Deferred interest is common in adjustable rate mortgages (ARM) where the rate increases regularly. Payments are deferred for an initial period or the borrower can just add back some of the payment increases back into the loan when rates adjust higher.
A lot of mortgage brokers suck people in with the idea of a payment cap, a payment amount that cannot be exceeded even if interest rates jump.
The problem is that the payment cap doesn’t really protect you from anything. If rates go up and the payment necessary to pay off your loan increases past the cap, that extra money doesn’t just go away. It is added back to your loan as deferred interest.
This is the third scenario in the example above, where money is just added back to your loan. Deferred interest on a mortgage can put you upside-down and make it impossible to sell your house without losing money. You may also have a huge balloon payment at the end of your loan.
How Does Deferment Affect My Student Loans?
Student loan deferment isn’t the same thing as deferred interest so I thought I should mention it here before there’s any confusion. There are two special programs set up for student loans with one very big difference.
Most student loan payments are deferred until you graduate or stop attending school for a certain number of hours. Usually payments are deferred for six months after you graduate and most of the time, interest does not get added back to your loan.
I’m saying, “most of the time,” here because I don’t want you to get in trouble not paying your student loans. Always check to make sure your student loan deferment does not require interest payments, sometimes they do.
Forbearance is another type of student loan help that can temporarily suspend your payments if you lose your job, have unexpected medical bills or run into financial problems.
Your loan servicer has the final say whether to allow you a forbearance period BUT you almost always are required to pay at least the interest amount each month.
You can see that it is very important not to confuse student loan deferment with interest deferment in other loans. I took advantage of student loan deferment through undergrad and grad school and it was great not having to make payments on the loans. It didn’t cost any extra interest and is a great program for students.
What is Deferred Principal?
Technically, deferred principal is when you don’t make principal payments on your loan and it’s added back to the amount you owe. You might still be making interest payments so the loan doesn’t necessarily grow but you’re still not paying the loan off.
There really isn’t much different between deferred interest and deferred principal when you think about it.
Whether you are adding interest or principal back to your loan, the outcome is the same. If you are not making large enough payments to pay off the loan, you are going to be paying more interest and possibly have a big balloon payment at the end.
How Much Will Deferred Interest Cost Me?
Here’s another example of how much deferred interest can end up costing you in the long run.
Let’s say in the example above, the $200,000 mortgage at 4.75% for 360 months, you pay off the interest accumulated over the first 24 months but make no principal payments.
This is called an interest-only loan and would mean your monthly payment is $791.66 to cover the interest.
The problem is that you would still be looking at a higher payment ($1,077) when you start paying principal and interest. You pay $19,000 in interest over the first two years and get nowhere…you still would have $200,000 left to pay on your loan.
How to Use a Deferred Interest Loan
I’m not saying deferred interest is always a bad thing. If you genuinely can’t make payments on your loan because of lost income or some unexpected bills then a deferment can save your financial skin.
If you aren’t able to make full payments on your loan, the first thing to do is to call your creditor. They want you to repay the loan and will work with you to make that happen. Not working with you on payments only means you’ll get behind and it’s very unlikely that you’ll ever pay off the loan.
If a creditor grants you a deferment, try to pay as much as possible even if they drop the required payment to zero for a few months. Remember, just because they aren’t requiring a payment doesn’t mean the payment you would have made is going away. It is going to be added to your loan and you’ll have to pay interest on it.
Keep making payments to the best of your ability.
Alternatives to Deferred Interest Loans
There are ways to beat a financial crisis without deferring interest or principal on your loans.
If the loan is small enough, you might just be able to pay it off with a debt consolidation loan. This is where you take out a new loan at a lower rate to pay off several other loans. The new loan will give you a month before you start making payments and the monthly payment may be lower.
If you can’t pay off the loan, you might try applying for an unsecured personal loan to cover short-term expenses. This will help get you back on your feet without having to defer interest on the loan or face a balloon payment.
Deferred interest on loans can help in a financial emergency but it isn’t quite the financial magic it seems. The money you don’t have to pay on your loan isn’t going away and could cause problems later. It will be added to your loan amount, causing your payments to increase or a balloon payment to be required at the payoff. Look at your options carefully before agreeing to defer interest or principal on your loan.
Read the Interest Rate Series
- The Shocking Difference Between APR and Interest Rate
- What You Don’t Know about Deferred Interest is Costing You Thousands
- Budgeting Help and Tips I Used to Save $54K in Interest
- Find your Interest Rate by Credit Score: Get your Best Rate
- What is Compound Interest Investment? [How to Get Rich on Any Income]
About the Author
Joseph Hogue is a financial expert and investment analyst. After serving in the Marine Corps, he started his career investing in real estate before becoming an investment analyst for some of the largest private investors. He's appeared on Bloomberg and on CNBC as an investment expert and has published ten books in personal finance. Now he helps investors reach their financial goals and invest in the stock market with some of the same advice he used when working for the rich.