What is Deferred Interest?
You've probably seen ads on TV or received offers in the mail advertising no interest for a specific period of time if you apply for a certain credit card or loan. This type of tempting offer is known as deferred interest. Deferred interest plans are most often associated with store credit cards, but they are also available for other types of credit cards or various loans - most often mortgages.
In terms of credit cards, if you are told you don't have to pay any interest for 12 months, you won't need to pay as long as you pay off your balance for the purchase by the end of the deferred interest period (12 months in this case). If you make any late payments or don't pay the balance in full during the allotted time period, you may have to pay the full amount of interest you expected to be deferred.
The credit card company is required to tell you the date by which you must pay off your balance to avoid being charged deferred interest. The information will be clearly displayed on the front page of your statement and the deferred interest purchase may even be shown as a separate balance from other purchases on which you can't defer interest.
In the example outlined above, where interest is deferred for 12 months, what happens if you fail to pay the full balance within the 12 month period? Well, you will be charged interest for each month on the balance you owed in each of the 12 months. In other words, in order to avoid paying interest you want to avoid, be sure to pay off your deferred interest balance before the deferred interest period ends. Do your best to pay more than the minimum payment each month in order to pay off the balance as quickly as possible.
Deferred Interest on Loans
When you get a loan, you typically make monthly payments and part of that payment represents interest. Over time, your balance on the loan decreases. However, when it comes to a deferred interest plan, your outstanding balance does not decrease as months or years go by. If you have a deferred interest mortgage or adjustable rate mortgage, you will have a payment cap but your interest rate increases. With deferred interested, your debt increases, because the difference can be added to your balance.
Deferred interest can pose a problem if it causes you to owe more on your home than it's worth (being upside-down in your mortgage). If you find yourself in this type of situation and you want to sell your home, it can be quite difficult or nearly impossible to do so. On the other hand, a deferred interest mortgage can be a good thing if you're expecting a substantial salary increase in the near future. Once you make more money, it will be easier to afford the higher payments over the life of the loan.
In general, when a loan's principal balance increases due to deferred interest, also known as negative amortization, it can create lower monthly payments. For example, if the interest payment of your adjusted rate mortgage is $1,000 and the terms allow for a reduced payment of $800, if you make the reduced payment, $200 will be added to the loan's principal balance. It is important to note that you can choose to waive the offer of deferred interest and make the full payment, because when you agree to a deferred plan, you must accept the possibility that the monthly payments will have to increase substantially at some point over the term of the mortgage.
In general, make use of deferred interest only after considering the potential impact on your future monthly budget. In terms of credit cards, you must be certain you can pay off the purchase during the deferred interest period in order to avoid paying the full amount of interest, applied retroactively to the entire original purchase price. In other words, if you see a credit card or loan advertisement boasting a no-interest offer, don't take it at face value. If you don't read the fine print of financial agreements, your deferred interest plan could lead to unexpectedly inflated costs.