What Is an Interest-Only Loan and How Does It Work?
Understanding the pros and cons of interest-only loans
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 you owe.
With an interest-only loan, you pay only the interest on the loan, not the amount of the loan itself. This results in lower monthly payments for a fixed period of time. Eventually, you pay off your full loan.
Interest-only loans have both benefits and disadvantages, and they are not appropriate for every mortgage or borrower. It’s critical to understand the pros and cons of postponing repayment with an interest-only loan.
How an Interest-Only Loan Works
An interest-only loan is a loan that temporarily allows you to pay only the interest costs, without requiring you to pay down your loan balance. After the interest-only period ends, which is typically three to 10 years, you must begin making principal payments to pay off the debt.
Monthly payments for interest-only loans tend to be lower than payments for standard amortizing loans. That’s because standard loans typically include your interest cost plus some portion of your loan balance.
Amortization is the process of paying down debt over time.
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 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.
Advantages of Interest-Only Loans
Interest-only mortgages and other loans are appealing because of low monthly payments. This has several advantages for borrowers, depending on your situation.
Buy a More Expensive Property
An interest-only loan allows you to buy a more expensive home than you would be able to afford with a standard fixed-rate mortgage. Lenders calculate how much you can borrow based (in part) on your monthly income, using a debt-to-income ratio.
With lower required payments on an interest-only loan, the amount you can borrow 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 makes it possible.
Free up Cash Flow
Lower payments provide more flexibility for how and where you put your money. If you want, you can certainly put extra money toward your mortgage each month, which allows you to mirror a standard “fully amortizing” payment.
An interest-only mortgage allows you to have more cash available for changes that you want to make to your new property. Or you can invest the money in something else, such as a business. Depending on your financial situation and goals, an interest-only loan can provide needed cash flow.
Most house flipping loans are interest-only in order to maximize the amount of money available for making improvements.
Keep Costs Low
Sometimes an interest-only payment is the only payment you can afford. You might choose an inexpensive property but still come up short on monthly funds. Interest-only loans give you an alternative to paying rent, which can also be expensive and uncertain.
When you have irregular income due to variable bonuses or commissions instead of a steady monthly paycheck, an interest-only loan can be a good way to manage expenses. You can keep your monthly obligations low and make large lump-sum payments to reduce your principal when you have extra funds.
You can also customize your amortization schedule with an interest-only loan. In many cases, your additional payment against the principal results in a lower required payment in the following months because the principal amount that you’re paying interest on decreases.
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.
Disadvantages of Interest-Only Loans
An interest-only loan lowers your monthly costs, but it does come with restrictions and drawbacks that can make it a risk for some borrowers.
You don’t build equity in your home with an interest-only mortgage. You can build equity if you make extra payments, but the loan is not designed to encourage early payments.
If you have an interest-only loan, you’ll have a harder time using home equity loans in the future if you ever need cash for upgrades or emergencies.
Paying down your loan balance is helpful for numerous reasons. One of them is reducing your risk when it comes time to sell. If your home loses value after you buy, it’s possible that you’ll owe more on the home than you can sell it for (known as being upside-down or underwater). If that happens, you’ll have to write a large check just to sell your home.
You buy a home for $300,000 and borrow 80%, or $240,000. If you make interest-only payments, you’ll owe $240,000 on that home (until the interest-only period ends).
If the home loses value and is worth only $280,000 when you sell it, you won’t get your full $60,000 from the down payment back.
If the price drops below $240,000 when you sell, you’ll have to pay out-of-pocket to repay your lender and get the lien on your home removed.
In some cases, you may finish your period of interest-only payments only to discover that your loan has generated additional interest in that time. This unpaid interest is then added to your loan balance so that your mortgage ends up being larger than the amount you actually borrowed.
Putting off the Inevitable
An interest-only loan keeps your monthly payments low for a few years, but it doesn't eliminate the need to eventually pay back the full loan. If your monthly payments only cover the interest on your loan, you’ll owe the same amount of money in 10 years that you owe now. Many borrowers sell their homes or refinance their mortgages to pay off an interest-only loan.
If you end up keeping the loan and the house, you’ll eventually have to start paying the principal with each monthly payment. Your loan agreement explains exactly when the interest-only period ends and what happens next.
Should You Use an Interest-Only Loan?
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 true 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 as a way to buy more than you can afford.
Consumer Financial Protection Bureau. "What Is an "Interest-Only" Loan?" Accessed Mar. 23, 2020.
Federal Deposit Insurance Corporation. "Interest-Only Mortgage Payments and Payment-Option ARMs." Accessed Mar. 23, 2020.
Mass.gov. "Interest-Only Mortgages & Option Adjustable-Rate Mortgages." Accessed Mar. 23, 2020.