Interest-Only Loan

An interest-only loan is a loan where, for a set period, the borrower pays just the interest. None of the payment reduces principal, so the balance stays the same. Some loans are interest-only for their whole term. Others start interest-only and then switch to regular principal and interest payments.

The payment is easy to figure. Multiply the balance by the annual rate, then divide by the number of payments in a year. On a hypothetical $2,000,000 loan at 8%, annual interest is $160,000, so the monthly payment is about $13,333. If the same loan were amortized over 25 years, the payment would be about $15,400. At the end of an interest-only term, the borrower still owes the full $2,000,000 as a balloon payment.

Many interest-only loans use a floating rate tied to a benchmark. In that case the payment changes whenever the rate resets, even though the balance does not.

Why it matters for lenders

Interest-only terms fit loans where repayment comes from a single future event. A bridge loan, a fix-and-flip loan or a construction loan is usually repaid when the property is sold or refinanced, not from monthly cash flow. Lower payments during the project make sense in that setting.

The tradeoff is that the lender's exposure does not shrink over time. If the property's value falls, there is no paydown cushion. That is why bank examiners in the US flag loans that are renewed again and again on an interest-only basis without other protections. Lenders offset the risk with lower loan-to-value limits, shorter terms, extension tests and close tracking of the exit plan.

Interest-only loans also change servicing. Interest on construction loans is often charged only on the amount drawn so far, so the bill changes every month. Some loans pay interest from an interest reserve set aside at closing rather than from the borrower's pocket.

How it works in practice

A private lender funds a 12-month, interest-only bridge loan on a small apartment building. At closing, the servicing team records the rate, the day-count method, the first payment date and the maturity date. Each month, the system bills interest on the outstanding balance.

Halfway through, the borrower asks for a six-month extension. The lender reviews the leasing progress and the refinance plan, charges an extension fee and records the new maturity date.

In a spreadsheet, the risk is that interest is billed on the wrong balance after a partial paydown, or that the new maturity date never reaches the alert list. Keeping the terms, balance and dates on one loan record avoids both.