What it does
With an interest-only loan you pay just the interest for a set time, often 3 to 10 years, so the balance doesn't go down. Afterwards you either repay the whole loan over the years left, which raises the payment even if rates stay the same, or you owe the balance at once as a balloon payment.
How it's calculated
Payment after = L × i ÷ (1 − (1 + i)−m), m = months left in the term
Balloon = the full loan amount, due at the end of the interest-only period
Worked example
$400,000 at 6.5%, interest-only for 10 years on a 30-year term:
Years 11–30: $400,000 over 240 months = $2,982.29 a month
Total interest is $575,750. A regular 30-year loan at the same rate costs $2,528.27 a month and $510,178 in interest, so the lower early payment costs about $65,572 more overall.
As a balloon loan, you'd pay $2,166.67 a month for 10 years ($260,000 of interest) and still owe the full $400,000.
Reference: interest-only payment per $100,000
| Rate | Monthly interest per $100,000 |
|---|---|
| 5% | $416.67 |
| 6% | $500.00 |
| 7% | $583.33 |
| 8% | $666.67 |
| 9% | $750.00 |
Limitations
- Many interest-only loans have adjustable rates. Try the ARM calculator for rate changes.
- Balloon payments generally aren't allowed in Qualified Mortgages, with limited exceptions.
- If you can't pay or refinance a balloon, you could lose the home.
- Interest-only payments don't build equity. If home prices fall, you could owe more than the home is worth when the payment rises.
When an interest-only loan can make sense
It may suit someone with uneven income, such as commission or bonuses, who plans to pay down principal when money comes in, or someone who expects to sell before the interest-only period ends. Either way, check that you could afford the higher payment if your plans change, because the jump can be large.