Home Loans Part 2 (Deferred Interest)
In part one (home loans), I looked at a variable loan based on a ad I received with a 10-year teaser of .385% going to a fixed 6.75% after the teaser period compared to a 30-year fixed at 6% based on a 300K loan.
Now lets complicate the offer. In the fine print it mentions that the interest between .685% and 6.75% is deferred. What does this mean? Simple, you have to start to pay the interest for that period at the end of 10-years or in other words the loan increases by the amount of deferred interest.
Let’s do a compare to see how this works out:
First in part one, you have an amortization schedule so you know your total payments, interest, and time of loan. We must now construct this for the second loan, which is done in a few steps.
(see bottom of post for an amortization schedule you can use!)
Step 1: This loan asses 6.75% on the loan balance, but your payment is applied as if you had a loan at .385%. Remember we are trying to compare this to a 30-year fixed by keeping the monthly payment equal. Our monthly payment is therefore $1,799.
Let’s build the schedule:
Loan Interest (.385%/12) Deferred Interest Payment New Balance
Payment 1 and 2:
$300,000 $96 $1,688 $1,799 $298,297
$298,297 $96 $1,678 $1,799 $296,594
At payment 120 (10 Years)
$93,489 $30 $525 $1,799 $91,720
At payment 120 the principle balance before we add in the deferred interest is $91,720. If you add up all the deferred interest ($133,242), we now have to add this back into the loan for a new loan balance of ($93,489+$133,242) =$226,731.
Key – The deferred interest is calculated by (6.75%-.385%) X Loan balance for each month. (I have assumed the deferred interest does not accumulates interest in the 10-year period)
After 10-years of payments your loan balance would be $226,731 assuming you paid the loan like a 6% 30-year fixed.
Now look at payment 120 on the 30-year fixed amortization schedule and you will see your loan balance is $251,000. Over the first 10-years, you reduce your loan by an extra $24,269 assuming interest does not accumulate on the deferred interest. If it does it adds an extra $66,000 thereby making your balance $292,731 meaning that over 10-years you only paid your principle down by $8K.
Tip – If there is deferred interest, make sure you understand how it is treated. It can make a very large difference when comparing loans.
It is clear, if the deferred interest accumulates interest this loan is not better than a 30-year fixed. If it does not, there is more work to do.
You must know determine which loan pays out better in the remaining 20-years. For the 30-year fixed you know you have 20-years left. For the variable loan you must continue your amortization schedule with the same payment of $1,799, starting with a balance of $226,731 and assuming a 6.75% interest rate. If you do this you will find that your balance reaches zero around payment 342.
This loan in this case would save you 18 payments of $1,799 clearly making it a better choice if you make the same loan payment as a 30-year fixed.
Where consumers get into trouble with a loan like this, is by paying a lower payment. Let’s just take a quick look at how much trouble you could get in.
The advertised payment on this loan was $256 per month. Wow sounds great, but here is what happens at the end of 10-years:
New Loan Balance: $280,459 + Deferred interest ($196,002.31) = $476,627.67. Payment increases to pay the $476K over the remaining 20-years at 6.75%.
Your payment is now: $3,624.
Wow, not only does your loan balance after 10-years increase by $176,627, but your payment increase $1,824 vs. a 30-year loan configuration at the start. You can see why many consumers would default on this loan. To make matters worse, if you can not afford the new payment and your house has not appreciated, you will not be able to refinance. Nothing left to do but default and give your house to the bank.
Seems like a sour deal to me.
Tip- Always know your adjusted payments at the end of any fixed interest rate periods. Remember they will be based on the remaining life of the loan, not 30-years.
In Summary, I would not suggest this loan to anyone unless they are completely diligent about sending as much if not more than what they would send on a conventional 30-year loan. I do not view lower payments as a benefit, buy the house you can afford. The only thing this loan offers is a way to pay principle down fast and pay interest on a lower balance after 10-years. If you can do this, by all means look at these types of loans, but make sure to do the math to really understand what you are agreeing to.
As always, make sure to read the fine print, any short term fees, balloon balances, accrued interest on deferred interest, or any other extra fee can quickly make this loan very bad.
Your 10 Items to Check for Every Home Loan Offer
- Read the fine print. They all have it. It can be hidden, disguised, or on a web-site. If you don’t understand something that impacts the payment, interest, or balance of the loan ask someone that does or don’t sign the loan.
- If the offer advertises very low payments there is a catch: Banks are in the business to make money. Ask yourself if you paid the loan back in the way it is being advertised how do they make money?
- Know how to calculate payments and interest. You need to know this information in order to compare loans and determine the best strategies to take.
- Do not sign a loan you can not afford. This may seem obvious, but it happens all the time with interest only, deferred interest, or teaser rate loans. Know what your payment is after the promotional rates.
- If you do sign up for a promotional loan do not pay the promotional rate: Truth is, you will find yourself in a worse situation if you typically pay the promotional payment. Either interest accrues or your loan balance does not reduce. In either case, when it comes time to pay the real amount you will find yourself with a much higher payment that you may not be able to afford.
- Discipline: As in the example loan above, it can be beneficial to use promotional rates to quickly reduce principle balances, however, you have to be diligent in the amount you pay and know exactly what to pay to make the loan make sense.
- Do research: Find facts about the type of loan you’re considering, even do searches on the bank offering the loan to see if consumers have complained.
- Don’t ever sign anything that adds balances: Another thing that seems obvious, but there are loans out there that actually add to your balance as time goes on. These are usually associated with low payment type of offers.
- Check with your tax advisor: Different loans have different tax affects. Check with your tax prepared to see how your loan will impact your taxes each year.
- Read Everything: It is a must and is stated again. The better the loan seems, the more time you should spend reading the paper work. If you have questions, ask someone or search on the internet.
Places I like to start Loan Shopping
Be careful and happy loan hunting.