What is a deferred interest mortgage?

A deferred interest mortgage is the same as a negative amortization loan. When you make normal mortgage payments, a portion of it goes towards the interest you owe on your loan and the rest goes towards your principal. In this way, your principal grows smaller and smaller over time until finally, you pay off your mortgage completely and owe nothing.

With a deferred interest mortgage, the opposite happens. Your mortgage payment covers only a portion of the interest that you owe based on how much you are borrowing. The remainder of what you should have paid in order to cover your interest liability is then tacked on to your principal. In this way, the amount you owe grows larger and larger with each year.

There are two common ways you can find yourself in a deferred interest or negative amortization loan. The most common is through an adjustable rate mortgage (ARM) with a maximum payment option. With an adjustable rate mortgage, your interest rate will vary from year to year. Therefore, the amount you’ll have to pay in interest before having your mortgage payments applied to your principal will increase or decrease year to year. To protect consumers from unaffordably high monthly payments which would lead them to default, mortgage lenders offer ARMs where the monthly payment is capped at a certain amount. The consumer can pay this amount without going into default, even if this does not cover the entire interest due. In this situation, the interest then gets tacked on to the principal.

The other way someone might obtain a deferred interest mortgage is through a graduated payment mortgage, or GPM. These are mortgages where the monthly payment begins very low, with much of the interest deferred, and then eventually, the mortgage payment grows larger to cover the deferred interest. This type of loan costs more in the long run, since the principal grows larger during the time of deferred interest, but it is more affordable in the near term. A graduated payment mortgage allows young borrowers to afford a more expensive home than they might be able to with a conventional mortgage. This type of deferred interest mortgage is usually taken when the borrower anticipates a significant pay raise or increase in income over the next few years.

Another way that a deferred interest mortgage can be advantageous is if you expect the value of your home to rise significantly during the loan term. For example, if you buy a home for $100,000 and then sign up for a deferred interest mortgage that will grow your principal to $125,000, but sell your home for $150,000 in the next year or so, you could be realizing a tidy profit.

That all being said, a deferred interest mortgage isn’t something to pursue lightly. Deferred interest mortgages are for those with well-defined financial plans and contingencies. Depending on how you approach the debt instrument ,a deferred interest mortgage could be a strategic piece of your financial plan, or it could be a debt trap that bankrupts you at an accelerated pace.