Deferred interest is the interest charge on a debt that has been added to the principal balance due to accrual caused by unpaid interest.
Not all types of credit facilities have contractual terms that allow for deferred interest.
In such cases, borrower might be requested to make additional payments to settle the outstanding interest or be charged with a penalty.
Or borrowers might be required to make additional payments after the final scheduled payment to settle the balance in order to be released from the debt.
Deferred interest policies tend to be active in regular term loan products such as mortgages.
How deferred interest can come about
When the monthly scheduled installment payments for a loan is calculated at the point of loan commencement, the monthly payment would consist of principal and interest that is based on the assumption that the facility would be held for the full term, without any partial or full redemption.
But sometimes, monthly payments are fixed amount but interest rates can fluctuate.
When interest rates rise, resulting in a higher interest charge to the borrower, the fixed monthly payment would not be able to cover the actual interest due.
The excess would then be accrued as deferred interest and be added to the principal loan balance.
For example, a $500 monthly payment might consist of $400 principal and $100 interest. Should a sudden hike in interest rate make the interest due $150 instead of $100, the payment would become $550 instead of $500. But the contractual monthly payment is still at $500. So after paying the debt obligation of $500, $50 is left unpaid and becomes deferred interest.
This can lead to what is commonly known as negative amortization where the principal balance increases instead of decreases with each payment.
Interest-only loans are most vulnerable to such situations.
The ultimate implication is that if the homeowner sells the house, the sales proceeds might not be enough to pay off the outstanding home loan.
This can occur during catastrophic economic events when home value drops while interest rates rise.