An interest-only loan requires the borrower to pay only the interest accrued on the principal balance for a specified period. The amount due each period is determined by multiplying the outstanding principal by the loan’s interest rate and dividing by the number of payment periods in a year. For example, a $200,000 loan at a 5% annual interest rate, paid monthly, would result in a monthly payment of $833.33 (calculated as $200,000 * 0.05 / 12). This contrasts with a traditional amortizing loan, where each payment includes both principal and interest.
This type of loan offers lower initial monthly payments, which can be attractive to borrowers who anticipate increased income in the future or are seeking to free up capital for other investments. Historically, interest-only loans have been used to purchase properties that borrowers plan to renovate and resell quickly, or by individuals who believe their income will increase substantially before the repayment period ends. However, it is crucial to recognize that after the initial period, the loan typically converts to a traditional amortizing loan, leading to significantly higher monthly payments that include both principal and interest repayment.
