What is an interest deficiency?
An interest deficiency is the accrued interest owed that remains after a borrower has made their monthly payment. This may result in negative amortization on some adjustable rate loans. Negative amortization is a financial term referring to an increase in the principal balance of a loan caused by an inability to cover the interest due on that loan.
Key points to remember
- An interest deficiency occurs when the accrued interest due on the payment of a debt is not fully covered.
- This can happen on a variable rate loan where an interest rate cap limits monthly payments to less than the total interest otherwise due.
- Interest deficiencies on ARM mortgages can result in negative amortization, resulting in a longer repayment period for the loan.
How Interest Deficits Work
Interest deficiency is a feature of adjustable rate mortgages (ARMs), in which the interest rate applied to the outstanding balance varies throughout the term of the loan. When rate caps limit monthly loan repayments, homeowner payments may be less than the actual interest owed. This unpaid interest increases the outstanding principal balance of the loan, which is called negative amortization.
While negative amortization protects borrowers against the payment shock associated with a sudden increase in the ARM interest rate, it will take longer to fully amortize the loan. If interest rates continue to rise, the equity in the home will decrease rather than increase, unless the price of the home increases. Most mortgages have limits on interest forgone, to protect both the borrower and the lender. A lifetime cap is the maximum upper limit interest rate allowed on an ARM. The ceiling applies to the life of the mortgage. This ceiling informs the borrower of the maximum interest rate he could pay during the term of the loan.
Payment shock is the risk that the scheduled future periodic payments of a loan could increase significantly and cause the borrower to default, and is associated with ARMs.
Interest deficits in MBS
In the mortgage-backed securities (MBS) market, interest shortfalls occur when the interest distributed is less than the amount of accrued interest from mortgage prepayments. Interest deficiency occurs when fees and expenses associated with distressed loans reduce the amount of interest available to be paid on a mortgage-backed security. If there is an interest shortfall, the interest is deferred, with the subordinate classes generally being allocated first, with the more senior tranches being repaid first.