Interest-only Loan
Definition and meaning of Interest-only Loan in real estate.
An interest-only loan is a mortgage where the borrower is required to pay only the interest on the principal balance for a set period, leaving the original principal balance unchanged.
In more detail
During the initial interest-only phase, which typically lasts between five and ten years, the monthly payments are significantly lower because no money is going toward paying down the principal. Once this period ends, the loan converts to a standard amortizing mortgage, and the payments increase substantially to pay off both the principal and interest over the remaining term.
Borrowers often use these loans for short-term strategies, hoping the property value will increase or their income will rise before the payments adjust. However, these loans carry higher risk because the borrower builds no equity through regular payments during the initial phase.
Key facts
| Category | Mortgages & Financing |
|---|---|
| Typical duration | Five to ten years for the interest-only phase |
| Risk level | High, due to payment shock when amortization begins |
| Primary benefit | Lower initial monthly payments |
An investor buys a rental property using a ten-year interest-only loan, keeping their initial monthly payments low to maximize cash flow, with the plan to sell the property before the amortization period begins.
Frequently asked questions
Do you build any equity with an interest-only loan?
You do not build equity through principal payments during the interest-only period, but you can still build equity if the market value of the property increases.
What happens when the interest-only period ends?
The monthly payment will increase, sometimes dramatically, because you must start paying both interest and the principal balance over the remaining life of the loan.