What Is an Interest-Only Loan?

Definition & Examples of an Interest-Only Loan

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With an interest-only loan, your loan payments are only enough to cover the loan's interest.

Learn more about interest-only loans and their pros and cons.

What Is an Interest-Only Loan?

With most loans, your monthly payments go toward both your interest costs and your loan balance. Over time, you keep up with interest charges and gradually eliminate the debt owed.

With an interest-only loan, you pay only the interest on the loan, not the amount of the loan itself (also known as your principal). This results in lower monthly payments for a fixed period. Eventually, you're required to pay off the full loan either as a lump sum or with higher monthly payments that include principal and interest.

How an Interest-Only Loan Works

Monthly payments for interest-only loans tend to be lower than payments for standard loans. That’s because standard loans typically include interest costs plus some portion of the loan balance. The process of paying down debt over time is called amortization.

To calculate the monthly payment on an interest-only loan, multiply the loan balance by the interest rate, then divide by 12 months. If you owe $100,000 at 5%, your interest-only payment would be:

$100,000 * 0.05 = $5,000 per year / 12 = $416.67 per month

Interest-only payments don’t last forever. You can repay the loan balance in several ways, depending on the terms of your loan:

  • The loan eventually converts to an amortizing loan with higher monthly payments. You pay the principal and interest with each payment.
  • You make a significant balloon payment at the end of the interest-only period.
  • You pay off the loan by refinancing and getting a new loan.

To calculate and compare interest rates, use an interest-only loan calculator to do the math for you, and compare the payments to fully amortizing loan payments.

Pros and Cons of Interest-Only Loans

Pros
  • Can buy more expensive property

  • Free up cash flow

  • Keep costs low

Cons
  • No equity

  • Risk of being underwater

  • Negative amortization

  • They're temporary

Pros Explained

  • Buy a more expensive property: Lenders calculate how much someone can borrow based (in part) on how their monthly income compares to their monthly debt payments, including the potential mortgage payment. This is called a debt-to-income ratio. With lower required payments on an interest-only loan, the amount that can be borrowed increases significantly. If you’re confident that you can afford a more expensive property—and able to take the risk that things won’t go according to plan—an interest-only loan could make it possible.
  • Free up cash flow: Lower payments provide more flexibility for how and where you put your money. You can certainly put extra money toward your mortgage each month, which allows you to mirror a standard “fully amortizing” payment. Or you can invest the money in something else, such as a business.
  • Keep costs low: Sometimes an interest-only payment is the only payment you can afford. Interest-only loans offer an alternative to paying rent, which can be expensive and uncertain. If you have irregular income, an interest-only loan can be a good way to manage expenses. You can keep monthly obligations low and make large lump-sum payments to reduce the principal when you have extra funds.

Most house flipping loans are interest-only to maximize the amount of money available for making improvements.

Cons Explained

  • No equity: You don’t build equity in your home with an interest-only mortgage. Equity is the difference between what your home is worth and the amount you owe on your mortgage. It can help you buy a new home, and you can borrow against it using home equity loans and home equity lines of credit in the future.
  • Underwater risk: Paying down your loan balance reduces your risk when it's time to sell. If your home loses value after you buy, it’s possible to owe more on the home than you can sell it for (also known as being upside-down or underwater). If that happens, you’ll have to write a large check just to sell the home.
  • Negative amortization: In some cases, you may finish your interest-only payments only to discover that the loan has generated additional interest in that time. This unpaid interest is added to the loan balance so that the mortgage ends up larger than the amount you actually borrowed.
  • They're temporary: An interest-only loan keeps monthly payments low for a few years, but it doesn't eliminate the need to eventually pay back the full loan. If the monthly payments only cover your loan interest, you’ll owe the same amount of money in 10 years that you owe now. Many borrowers sell their home or refinance their mortgage to pay off an interest-only loan.

Check with your lender about the rules for paying down your principal, as some loans won’t adjust the payment or the payment doesn’t change immediately.

Is an Interest-Only Loan Worth It?

Interest-only loans aren’t necessarily bad, but they’re often used for the wrong reasons. If you have a sound strategy for how you will use the extra money (and a plan for getting rid of the debt), then they can work well.

It’s important to distinguish between actual benefits and the temptation of a lower payment. Interest-only loans work when you use them as part of a sound financial strategy, but they can cause long-term financial trouble if you just use interest-only payments to buy more than you can afford.

Key Takeaways

  • With an interest-only loan, your loan payments are only enough to cover the loan's interest.
  • Eventually, you're required to pay off the full loan either as a lump sum or with higher monthly payments that include principal and interest.
  • Monthly payments for interest-only loans tend to be lower than payments for standard loans. 
  • Interest-only loans can help you buy a more expensive property and free up your cash flow, but they don't build equity. You also run the risk of being underwater. 
  • An interest-only loan can be worthwhile if you have a plan for managing your principal payments.