Deferred Payments – Letting Borrowers Kick the Can

Having the option to allow the borrower to defer their interest payments until they pay off the loan can be a useful arrow in the lender’s quiver.  Having this option, even if used seldomly, offers a point of differentiation amongst other lenders.  This article will explore the features of this option and the considerations one must take before using it.

What it Does and Doesn’t Do

The deferred payments option is fairly straightforward.  The interest payments will be deferred until the earlier of i) the maturity date, ii) payoff of the loan, or iii) an event of default.  If the borrower defaults but then cures their default the lender may choose to allow the borrower to continue deferring payments or begin making regular monthly payments.  Keep in mind, however, that only the interest payments on the loan are being deferred.  If the lender also requires servicing fees, or tax or insurance impounds to be paid, then these payments will still be collected each month while the interest on the loan is deferred.

This also means that the deferred payments option is only available on interest-only loan as it would make little sense to have principal payments deferred.  Likewise, the debt service / interest reserve is not available when using the deferred payment option since no interest is being paid during the term of the loan.

Capitalized Interest Feature

In addition to deferring the interest payments, you may also choose to capitalize the deferred interest.  If this additional feature is selected, then each interest payment that gets deferred will be added to the principal balance of the loan and thus the next interest payment (which is also deferred) would be slightly larger because interest is now calculated based on this higher principal balance.   Make sure your loan servicer is aware or that your loan servicing software can handle capitalization before you choose this option.

State Law Restrictions

There are a few restrictions or limitations from certain states when the capitalized interest feature is used.  These restrictions are relevant when you select any one of the following states for the governing law of your loan documents:  Oregon, Georgia, New York, North Dakota, or West Virginia. 

• (Oregon)  Loans that include a capitalized interest feature provision must follow the federal “ability to repay” regulations which are normally applicable only to consumer loans, unless the loan:
  • Has a term of less than 18 months;
  • Has a principal balance of $50,000 or less and the aggregate LTV for all liens on the property is 50% or less; OR
  • Has a line of credit provision.

In addition, any loan that includes a capitalized interest feature provision may not have a separate prepayment premium which extends beyond 24 months after closing.

• (Georgia)  Georgia law specifically allows capitalized interest on loans in 1^st priority.  Junior liens (2^nd priority and below), however, do not have this allowance and it may be inferred that interest capitalization is not enforceable for junior liens.  You should consult with an attorney for further information.

• (New York)  Capitalized interest is prohibited if:
  • The loan amount is $250,000 or less, OR
  • Any property which secures the loan is owner-occupied AND is a 1-2 unit residential dwelling. 

It is not clear whether the secured property in question must be a New York property for the prohibition to apply.  You should consult with an attorney for further information.

• (North Dakota)  Capitalized interest is prohibited unless:
  • The Borrower is a
    • Corporation
    • LLC
    • Trust
    • General Partnership
    • Limited Partnership
    • Other Association which files a partnership tax return;  OR
  • The Loan amount is greater than $35,000.

• (West Virginia)  Capitalized interest is prohibited on all loans.

Concluding Thoughts

A line of credit loan is a fantastic option for some lenders and it opens up a new avenue of opportunity.  The risks associated with priority as to future advances can be mitigated by choosing the appropriate language version and routinely obtaining title rundowns.  If you should have any questions about this new feature or how to use it please contact me at m.gunter@lightningdocs.com.