What it means
On a normal repayment mortgage, each monthly payment is split between interest and a slice of the principal, so the debt shrinks a little every month. On an interest-only mortgage that second slice is removed, so the lender is paid purely for the use of its money and the debt at the end of year five is identical to the debt on day one.
The appeal is cash flow. A lower monthly outgoing frees up money for other uses, which is why the structure is common with property investors, developers and businesses that own their premises and would rather put spare cash into stock, equipment or hiring than into paying down a loan early.
The arithmetic is simple enough to do in your head: multiply the outstanding balance by the annual interest rate, then divide by twelve. Because the balance never falls, the payment only changes when the interest rate changes, which makes an interest-only loan far more sensitive to rate rises than a repayment loan of the same size.
The catch sits at the end of the term. Lenders normally require a credible repayment strategy, meaning evidence of how the principal will be cleared, and if the plan was "the property will be worth more by then" and the market has moved the other way, the borrower can be left with a balance they cannot refinance.
Part-and-part deals are a common middle ground, with some of the loan on interest-only terms and the rest on repayment terms. Many commercial property loans also blend the two, using an interest-only period for the first year or two while a building is being refurbished or let, then switching to full repayment once rental income has settled.
In practice
Real-world examples.
Example
A dental practice buys its own surgery with a $600,000 loan and negotiates two years of interest-only payments while it fits out the building and rebuilds its patient list. The lower payments protect cash flow during the disruption, and the loan converts to full repayment in year three once revenue has recovered.
Example
A buy-to-let investor holds four flats on interest-only mortgages so that rent comfortably exceeds the monthly interest, generating spare cash each month. When one tenancy ends and rates rise at the same time, the investor discovers the margin was thinner than it looked and sells one flat to reduce total borrowing.
Example
A family manufacturing business refinances a $1,200,000 factory loan onto interest-only terms for eighteen months to fund a new production line. The finance director sets up a separate sinking fund of $15,000 a month so the principal repayment does not arrive as a surprise.
Formula
Calculation
Monthly interest-only payment = Outstanding loan balance x Annual interest rate / 12
Take a $400,000 commercial property loan at a 6% annual rate. Annual interest is $400,000 x 0.06 = $24,000, so the monthly payment is $24,000 / 12 = $2,000. The equivalent 25-year repayment mortgage at the same 6% rate would cost $2,577.21 a month, so the interest-only route saves $577.21 every month. Over a five-year interest-only period the borrower hands over 60 x $2,000 = $120,000 in interest and still owes the original $400,000 on the final day.Case study
Seen in the real world.
Harborline Storage Ltd is a fictional self-storage operator used here purely as an illustrative case. It bought a warehouse for $2,000,000 with a $1,400,000 interest-only loan at 5%, paying $70,000 a year in interest while it converted the shell into 300 storage units.
The plan was sound on paper: once occupancy reached 80%, rental income would support a full repayment mortgage. Occupancy stalled at 55% for two years because a competitor opened nearby, and when the interest-only period ended the lender would only refinance $1,100,000, leaving a $300,000 gap.
The owners closed the gap by selling a small adjoining yard and injecting personal capital, then moved the remaining balance onto a fifteen-year repayment schedule. The illustrative lesson is that an interest-only mortgage borrows time, not money, and the repayment plan needs to survive a bad two years as well as a good one.
Watch out
Common mistakes.
- Treating the low monthly payment as the true cost of the loan, when the principal is still owed in full and simply sits waiting at the end of the term.
- Relying on rising property prices as the repayment strategy, which turns an ordinary loan into a bet on the market.
- Forgetting that because the balance never falls, a rate rise hits the payment much harder than it would on a repayment mortgage that has been shrinking for years.
Questions
People also ask.
Does an interest-only mortgage cost more overall?
Usually yes, because interest is charged on the full balance for the whole term rather than on a falling balance.
Can I pay down some principal voluntarily?
Most lenders allow overpayments up to an annual limit, and every dollar repaid immediately reduces the monthly interest charge.
Why do lenders offer them at all?
They suit borrowers with lumpy income or a clear exit such as a sale or refinance, and the lender still holds the property as security.
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