What it means
In a standard repayment mortgage, each payment covers the interest for the month and also a slice of the original loan. In a deferred interest mortgage, the minimum payment is set below the monthly interest.
The gap is not forgiven; it is added to the balance, which is why this feature is also called negative amortisation, meaning the loan balance goes up instead of down. These loans are designed for borrowers who expect their income to rise, or who want to keep early payments low.
Examples include young professionals expecting promotions, or property investors who plan to sell or refinance before the larger payments begin. The attraction is cash flow relief at the start.
The danger is that the balance can grow beyond the value of the property, particularly if house prices fall. Most contracts include a cap, often a percentage of the original loan, at which the payments must be recalculated to repay the loan in full.
That reset can cause a sharp rise in monthly payments, sometimes called payment shock. Because of these risks, many regulators restrict or closely supervise such products, and lenders must explain the terms clearly.
Anyone considering this kind of loan should ask for a schedule showing the balance at each year end, under different interest rate scenarios. If the interest rate is variable, the schedule should show what happens if rates rise.
In business, similar structures appear in property development finance, where interest is rolled up into the loan and paid from the sale proceeds. The principle is the same: payments are postponed, and the cost is that the loan grows.
Careful forecasting is essential to ensure the project can repay the larger sum.
In practice
Real-world examples.
Example
A newly qualified doctor takes a mortgage with low minimum payments for the first five years. Her income is expected to rise sharply, but she knows the payments will be reset later and plans for it.
Example
A property investor buys a rental flat using a deferred interest loan, intending to sell within three years. The balance rises slightly in that time, and the sale proceeds repay it in full. The investor treats the extra interest as part of the cost of the project when calculating the profit on the flat.
Example
A couple find that house prices in their area have fallen after they took a deferred interest mortgage. Their loan balance has grown while their home value has dropped, so they cannot refinance easily. They now face the choice of selling at a loss, finding extra cash to reduce the loan, or waiting for prices to recover.
Formula
Calculation
Monthly interest = loan balance x annual interest rate / 12
Deferred amount = monthly interest - minimum payment
New balance = old balance + deferred amount
A borrower has a $300,000 loan at 6% a year with a minimum monthly payment of $1,000. Monthly interest = $300,000 x 0.06 / 12 = $1,500. The deferred amount = $1,500 - $1,000 = $500. The new balance is $300,000 + $500 = $300,500. If this shortfall repeated for twelve months, the balance would rise by roughly $6,000 (12 x $500), and slightly more once interest on the added amounts is included.Case study
Seen in the real world.
Greystone Row Developments is an illustrative, fictional company that bought an old warehouse to convert into flats. It financed the purchase with a loan on which interest was deferred and added to the balance for eighteen months.
The finance manager built a model showing the loan growing from $2,000,000 to about $2,180,000 before the first flats were sold. She also tested what would happen if sales were delayed by six months, and she presented the results to the board as a simple table with best, expected and worst cases.
Greystone Row is a made-up company, so the figures are for teaching only. The stress test showed that a delay would still leave enough value to repay the loan, and the board approved the deal knowing the exact limit of its exposure.
Watch out
Common mistakes.
- Believing the deferred interest is waived, when it is simply added to the balance and charged interest itself.
- Looking only at the low starting payment and ignoring the rise in payments when the loan is recalculated.
- Assuming property prices will always rise enough to cover the growing balance.
Questions
People also ask.
What is negative amortisation?
It is the increase in a loan balance that happens when payments are less than the interest charged, and it is the main risk to understand before signing.
Who might benefit from this type of loan?
Borrowers with low current income but strong expected growth, or investors planning to sell or refinance soon, may find it useful if they understand the risks.
What is a payment cap or recast trigger?
It is a limit, often a percentage above the original loan, at which the lender recalculates the payments so the loan is repaid over the remaining term.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%