Interest-only period

Before you rely on it

What to check

Model the payment for the first month after the period ends, not an average over the loan.

The common error

Where people go wrong with interest-only period

Budgeting off the interest-only payment. That figure was never the cost of the loan, and the step up at the end has caught borrowers who were current on every payment.

Worked through

Interest-only period in plain numbers

A $300,000 loan at 6% with a ten-year interest-only period has payments of $300,000 × 0.06 ÷ 12, or $1,500 a month. After ten years the balance is still $300,000. Then the loan amortizes over the remaining twenty years, and the payment becomes about $2,149. That is a 43% jump, with no change in rate, and a conventional 30-year loan at the same rate would have cost $1,799 from the start and reduced the balance by then; the interest-only years lower the early payment and postpone equity building. The catch comes when the schedule turns.

Easily confused

Interest-only period and its neighbours

An interest-only period is a phase within a loan, not a type of loan by itself. An interest-only loan may carry the whole term without repaying principal, ending with a balloon; a loan with an interest-only period then converts to an amortizing schedule. Neither is the same as a payment-option loan, which lets you choose among payment levels; the interest-only phase also differs from negative amortization, where payments are lower than the interest owed and the balance grows.

In real decisions

Where interest-only period turns up

Investors use interest-only periods to improve cash flow in the early years of a property; borrowers with variable incomes, such as commission earners, sometimes choose them. Construction loans often have interest-only phases; some borrowers plan to sell or refinance before the period ends. Lenders offer them to borrowers with strong credit and assets. Comparing the payment after the period ends with the payment during it shows whether the plan is realistic.

Know the edges

Where interest-only period stops being reliable

The balance does not fall during the interest-only years, so equity grows only if the home rises in value. Payments can jump sharply when repayment starts. Refinancing may be harder if values fall or rates rise. Variable rates add uncertainty. Total interest cost over the life is usually higher. Test the budget at the higher payment before agreeing, and have a plan for when the period ends.

Quick answers

What people ask about interest-only period

What happens when the interest-only period ends? The loan begins to amortize over the remaining term, so the payment rises, often sharply. Check the schedule and test your budget at the higher payment.

Can I pay principal during the period? Usually yes, and it lowers the balance. Confirm that extra payments are allowed and how they are applied.