The interest-only period on a loan is a period of time during which you’ll only pay interest on the loan. You do not repay any of the original loan balance (the principal), so you owe the same amount of money at the end of an interest-only period as you did at the beginning.
Interest-only periods offer some attractive benefits, but they can be dangerous to your financial health. Let's look at how these special offers work, why they're appealing, and when they can cause problems.
What Is the Interest-Only Period?
On a typical loan, you begin paying interest and principal (the loan balance) from the very first payment. However, on a loan with an interest-only period, you will pay only the interest for an agreed-upon period of time—usually a period of months or a few years. During that period, your payments will be much lower than they would be if you were also paying off the principal.
How the Interest-Only Period Works
If you are able to make a large down payment toward your loan, have good credit, and a decent income, your lender may offer you an interest-only option. They have to see you as a good candidate to repay the loan months or years down the road, so they won't offer this option to just anyone.
During the interest-only period, there is no amortization. Amortization occurs when borrowers pay off a debt over time with payments of the same amount at regular intervals, usually monthly. Each time the borrower makes a payment, they chip away at the loan balance. This isn't the case during interest-only periods.
Types of Loans With I-O Periods
Interest-only periods can be found in fixed-rate mortgages and adjustable-rate mortgages (ARMs). Young people or scholars who take out student loans also face interest-only periods, especially those who borrow large amounts of money to pay for schooling. Lines of credit, such as a home-equity line, may also have an interest-only period.
Pros and Cons of Interest-Only Periods
Building good habits
Low monthly payments at first
Option to refinance later
Significant jump in payment later
Difficult to predict the future
Not paying down your loan
- Building good habits: Some experts say that students who opt for interest-only periods on loans while in school are able to save money and can get into the good habit of making regular loan payments, lowering the risk that they'll forget to make payments once a student loan's grace periods end.
- Low monthly payments at first: Some borrowers prefer loans with interest-only periods because it allows them to make early payments that are significantly less than their later payments. This option may be attractive to young people just starting out who can't handle large payments at this point in their careers but expect to be more financially stable in the future, enabling them to make higher payments later in life.
- Option to refinance later: If terms such as the interest rate aren't favorable after the I-O period, you may be able to refinance with a more traditional loan.
- Significant jump in payment later: Longer interest-only periods increase the risk of "payment shock," where required payments dramatically jump to levels you can't afford. The longer you wait, the larger your required payment will be once you have to repay the principal. With that in mind, it may be better to have a relatively brief interest-only period.
- Difficult to predict the future: Many people don't experience the career or financial successes they expected. The death of a spouse, medical problems, or a job layoff may all make it more of a burden to make higher payments during the course of a loan. Accordingly, if you can afford to make higher payments at this time, it may not be wise to put off making these payments now.
- Not paying down your loan: If you only pay interest now, you will still have to repay the entire loan down the road. You could do this through refinancing, but that may prove difficult if your home doesn't increase in value and you haven't paid down any principal.
Is an Interest-Only Loan Period a Good Idea?
In most cases, it's best to take out loans that you'll pay down consistently over time. But there may be some situations in which an interest-only period makes sense. If you are reasonably confident that your income will increase down the road to meet the payment demands or you believe you can earn a better return investing that money elsewhere for a short time, an interest-only payment may work for you. Be sure you fully understand the risks before you sign on the dotted line.
- An interest-only loan period is an agreed-upon period of time in which a borrower only pays interest and no principal.
- During this period, the loan balance remains the same unless you choose to pay principal.
- The biggest benefit to these is the low monthly payment during the I-O period.
- The biggest downside is the "payment shock" that comes when the period ends and you have to begin paying the full loan payment.