What Is an Interest-Only Loan?

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DEFINITION

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

Definition and Example of 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"). That 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 Do Interest-Only Loans Work?

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 focusing on paying interest first while 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 x 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 find out what your payments might look like when the loan converts, use an amortization loan calculator that shows how your payments are broken into interest and principal.

Pros and Cons of Interest-Only Loans

Pros
  • Can buy a more expensive property

  • Free up cash flow

  • Keep costs low

Cons
  • No equity

  • Risk of going underwater

  • Negative amortization

  • Temporary loans

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 can 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. For example, you can 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 is generally more expensive than a loan. 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 available funds.

Most house flipping loans are interest-only to maximize the 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 your home's current market value and the amount you owe on your mortgage. It can help you buy a new home, or you can use it as a loan. Many banks offer home equity loans and home equity lines of credit if you have equity in your home.
  • Underwater risk: Paying down your loan balance reduces your risk if you decide to sell. If your home loses value after you buy it, 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 to the bank when you sell the home.
  • Negative amortization: In some cases, you may finish your interest-only payments and 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 initially borrowed.
  • The loans are temporary: An interest-only loan keeps monthly payments low for a few years, but it doesn't eliminate the need to pay back the full loan eventually. If the monthly payments only cover your loan interest, you’ll owe the same amount of money in 10 years that you owe now. As a result, many borrowers end up selling their homes or refinancing 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. Sometimes, the bank won't change the payment amount 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 using the extra money (and a plan for getting rid of the debt), they can work well.

It’s important to distinguish between actual benefits and the temptation of a lower payment. Interest-only loans work well when you use them as part of a sound financial strategy, but they can cause you long-term financial trouble if you 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'll need to pay off the entire 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 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 becoming underwater in your mortgage. 
  • An interest-only loan can be worthwhile if you have a plan for managing your principal payments.