An interest-only loan (IO loan) is a loan that lets you pay only interest for a period of time ― instead of making payments that include principal and interest.
With some interest only loans, you pay only interest for the first few years of the loan, and then you start making payments that include both principal and interest. Other interest-only loans have you pay just interest for the whole life of the loan, and then you pay off all the principal in one big payment at the end of your loan term.
How do interest-only loans work?
When you take out an interest-only loan, your monthly payments pay only for interest on your loan. They don’t pay off your initial loan balance, or principal.
In most cases, you’ll make these interest-only payments for a set period of time. For example, lots of lenders offer interest-only periods of three, five, seven, or 10 years. After that, you’ll start making payments that include both interest and principal.
Adjustable-rate mortgage vs. a fixed-rate mortgage
Based on a $200,000 loan and a 20% down payment
How do I pay off my interest-only loan?
You can pay off your interest-only loan…
- According to your amortization schedule
- At the end of your loan term in one big payment
- Using a refinanced (new) mortgage loan
- Using the proceeds from selling your home
Most borrowers pay off their interest-only loans by either refinancing or selling their homes.
Some lenders let you pay only interest over the entire term of your loan, then pay off the principal at the end of your loan term in one big balloon mortgage payment. Since you'd need a lot of cash for this type of balloon mortgages are much less common.
How do I sell my house if I have an interest-only loan?
An interest-only loan shouldn’t keep you from selling your home like normal.
However, interest-only loans don’t build equity during the initial period. If your home value goes down, you may end up selling your house for less money than you owe on your mortgage.
In that case, you’ll need to bring cash to your closing to pay off your loan balance.
Should I get an interest-only mortgage?
Cheaper monthly payments
Less equity in home
Lower starting interest rates
Potentially higher monthly payments
You can enjoy lower monthly payments, a lower interest rate, and a more expensive house right now — and worry about higher payments and a rising interest rate later.
An interest-only mortgage could be the right loan type for you if you plan to:
- Move before the end of your interest-only payment period
- Buy a house and flip it quickly
- Have a higher income by the time your principal payments kick in
But an IO loan is only smart if you know you can manage higher monthly payments down the line.
Not quite right?
FAQs about interest-only loans
You can make low monthly payments, since you pay just interest and no principal. If you plan to sell your house before principal payments start, an interest-only loan can save you money with those cheaper payments.
Say you buy a house for $300,000 and put 20% down. If you get an interest-only 7/1 ARM, you’ll only pay interest for the first seven years of your 30-year term. With a 4.5% interest rate, expect to pay around $900 per month during those first seven years. After that, your interest rate might go up, say, to 5%. You’ll start making higher monthly payments, around $1,300, on the principal for the rest of your loan term.
An interest-only loan doesn’t give you equity in your home. If you end up selling your home for less than you bought it, you’ll have to make up the difference with cash at closing time.
Interest-only can be a good idea if you plan to move or flip a home before you have to start paying down the loan principal. In those cases, you can save money by paying just interest, and you won’t have to worry about higher payments down the line.