How to Calculate Payment on an Interest-Only Loan

An interest-only loan is a type of financing where the borrower is required to pay only the interest on the loan for a specified period, without reducing the principal balance. This can be beneficial for those looking to lower initial monthly payments, improve cash flow, or maximize investment opportunities. However, once the interest-only period ends, the loan either converts to a fully amortizing loan or requires a balloon payment.

Understanding how to calculate interest-only loan payments is essential for borrowers looking to make informed financial decisions. The RefiGuide published this article to explain the formula used to calculate these payments and provide five real-world examples to illustrate different scenarios. Our team will teach you how to calculate the payment on and interest only loan and match you with multiple mortgage lenders that offer competitive home purchase and mortgage refinance loans.

How Interest-Only Loan Payments Are Calculated

To calculate the monthly payment on an interest-only loan, use the following formula:

Monthly Payment=Loan Amount×Annual Interest Rate12\text{Monthly Payment} = \frac{\text{Loan Amount} \times \text{Annual Interest Rate}}{12}Monthly Payment=12Loan Amount×Annual Interest Rate​

Key Factors That Influence Interest-Only Payments

• Loan Amount: The total borrowed principal.
• Interest Rate: The annual percentage rate (APR).
• Loan Term: The period during which payments remain interest-only (e.g., 5, 7, or 10 years).

Note: Since the borrower is only paying interest, the principal balance does not decrease during the interest-only period.

Example 1: Interest-Only Payment on a $300,000 Loan at 5%

Let’s assume a borrower takes out a $300,000 interest-only loan with a 5% annual interest rate.

Step-by-Step Calculation:

Monthly Payment=300,000×0.0512\text{Monthly Payment} = \frac{300,000 \times 0.05}{12}Monthly Payment=12300,000×0.05​ =15,00012=1,250= \frac{15,000}{12} = 1,250=1215,000​=1,250

✅ Monthly Payment: $1,250 per month during the interest-only period.

Example 2: Interest-Only Payment on a $500,000 Loan at 6%

Now, let’s assume a $500,000 loan with an interest rate of 6%.

Step-by-Step Calculation:

Monthly Payment=500,000×0.0612\text{Monthly Payment} = \frac{500,000 \times 0.06}{12}Monthly Payment=12500,000×0.06​ =30,00012=2,500= \frac{30,000}{12} = 2,500=1230,000​=2,500

✅ Monthly Payment: $2,500 per month.

Example 3: Interest-Only Payment on a $750,000 Loan at 4.5%

For a $750,000 loan with an annual interest rate of 4.5%, the calculation is:

Step-by-Step Calculation:

Monthly Payment=750,000×0.04512\text{Monthly Payment} = \frac{750,000 \times 0.045}{12}Monthly Payment=12750,000×0.045​ =33,75012=2,812.50= \frac{33,750}{12} = 2,812.50=1233,750​=2,812.50

✅ Monthly Payment: $2,812.50 per month.

Example 4: Interest-Only Payment on a $1,000,000 Loan at 7%

For a $1,000,000 loan at 7% interest, the calculation is:

Step-by-Step Calculation:

Monthly Payment=1,000,000×0.0712\text{Monthly Payment} = \frac{1,000,000 \times 0.07}{12}Monthly Payment=121,000,000×0.07​ =70,00012=5,833.33= \frac{70,000}{12} = 5,833.33=1270,000​=5,833.33

✅ Monthly Payment: $5,833.33 per month.

Example 5: Interest-Only Payment on a $200,000 Loan at 3.75%

For a $200,000 loan at 3.75% interest, the calculation is:

Step-by-Step Calculation:

Monthly Payment=200,000×0.037512\text{Monthly Payment} = \frac{200,000 \times 0.0375}{12}Monthly Payment=12200,000×0.0375​ =7,50012=625= \frac{7,500}{12} = 625=127,500​=625

✅ Monthly Payment: $625 per month.

Interest-Only Loan Payment Scenarios

Interest-only loans can be used for a variety of financial situations. Here are some common use cases:

1. Real Estate Investors

• Strategy: Real estate investors often use interest-only loans to maximize cash flow, as they can use the lower monthly payments to invest in additional properties.
• Example: A property investor with a 5-year interest-only period may use the extra cash to renovate the home and increase its value before refinancing.

2. Homeowners Expecting Future Income Growth

• Strategy: Borrowers expecting a salary increase in the future may choose an interest-only loan to reduce payments while their income is lower.
• Example: A doctor in residency might opt for an interest-only loan, knowing their income will rise substantially after completing training.

3. Borrowers Who Plan to Sell Before the Interest-Only Period Ends

• Strategy: Some borrowers use interest-only loans for short-term homeownership (e.g., relocating for work). Also consider an interest-only HELOC.
• Example: A corporate executive plans to sell their home within five years and uses an interest-only loan to reduce expenses in the meantime.

Transitioning from Interest-Only to Fully Amortizing Payments

Once the interest-only period ends, the borrower must either:

1. Begin paying principal and interest (which can significantly increase monthly payments).
2. Refinance the loan into another mortgage with better terms.
3. Pay off the remaining balance if the loan requires a balloon payment.

Example: Transitioning to Principal & Interest Payments

If the $500,000 loan at 6% becomes a fully amortizing 20-year loan after the 10-year interest-only period, the new monthly payment is:

New Payment=Loan Balance×Interest Rate/121−(1+Interest Rate/12)−N\text{New Payment} = \frac{\text{Loan Balance} \times \text{Interest Rate} / 12}{1 – (1 + \text{Interest Rate} / 12)^{-N}}New Payment=1−(1+Interest Rate/12)−NLoan Balance×Interest Rate/12​

For a $500,000 balance at 6% interest over 20 years, the new monthly payment would jump to $3,583 per month.

✅ Key Takeaway: Borrowers must prepare for a significant increase in payments once the interest-only period ends.

Pros & Cons of Interest-Only Loans

Pros:

✔ Lower Initial Payments: Increases affordability during the interest-only period.
✔ Cash Flow Flexibility: Ideal for investors and short-term borrowers.
✔ Potential Tax Benefits: Interest may be tax-deductible in some cases (consult a tax advisor).

Cons:

✖ Higher Payments After Interest-Only Period: Monthly payments increase significantly once principal repayment begins.
✖ No Equity Growth: The principal remains unchanged unless extra payments are made.
✖ Risk of Refinancing Difficulties: If home values drop or interest rates rise, refinancing may not be an option.

Is an Interest-Only Loan Right for You?

Interest-only loans can be valuable financial tools when used strategically. They offer lower initial payments and improved cash flow, making them popular for real estate investors, short-term homeowners, and those expecting future income increases.

However, borrowers must carefully consider the long-term implications, as monthly payments will increase once the interest-only period ends. Proper financial planning and an exit strategy are essential to make the most of this loan type.

Before committing to an interest-only loan, consult with a mortgage professional to determine if it aligns with your financial goals and risk tolerance.

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