Interest-Only Period

How an interest-only period works

Every commercial loan payment has two parts: interest, which is the cost of borrowing, and principal, which repays the balance. During an interest-only period the lender collects only the first part.

Monthly interest-only payment = Loan Balance × Annual Rate ÷ 12

Because no principal is repaid, the balance on the last day of the period is the same as on the first. The loan does not get smaller, so the payment does not either.

Interest-only comes in three common shapes:

• Partial-term interest-only. Interest-only for the first stretch of the term, then amortizing. A 10-year loan with three years of interest-only, then payments calculated on a 25- or 30-year schedule, is a typical structure. Your loan agreement states exactly when amortization starts and over how many years it is calculated.
• Full-term interest-only. Interest-only until maturity, when the whole principal is due as a balloon payment. Lenders who offer this typically want lower leverage and stronger coverage.
• Short-term interest-only. Bridge loans, hard money and construction loans are usually interest-only by design, because the plan is to sell, refinance or convert to permanent financing before principal payments would matter.

The term of the loan and the interest-only period are different things. A permanent loan may have a term of 5–10 yr and an interest-only period of only a few of those years. See the amortization explainer for how principal is repaid once the schedule starts.

Worked example: what the period saves and what it costs

Take a $1,400,000 loan at 6.5% with a 10-year term. The 6.5% is an example rate, not a current quote. Figures below use the same amortization arithmetic as the commercial mortgage calculator.

	Interest-only	Amortizing over 25 years
Monthly payment	$7,583	$9,453
Annual debt service	$91,000	$113,435
Monthly cash-flow difference	$1,870 in the borrower's favor while interest-only
Principal repaid in first 3 years	$0	$74,094

Now compare two 10-year loans. Loan A amortizes over 25 years from the first payment. Loan B is interest-only for three years, then amortizes over 25 years for the remaining seven.

• Loan A balance at year 10: about $1,085,159
• Loan B balance at year 10: about $1,201,801
• Loan B payment after year 3: jumps from $7,583 to $9,453, an increase of about 25%

Loan B saved $1,870 a month for 36 months, about $67,300 in total, and left $116,642 more principal outstanding at maturity. That larger balance is what you have to refinance or pay off, at the same time the payment is higher. The savings are real and so is the cost; whether the trade is worth it depends on what the borrower does with the cash in those three years.

The payment increase is also why the tail matters. If the amortization schedule after interest-only is shorter than 25 years, the jump is larger. Amortizing the same balance over 22 years instead of 25 raises the payment to about $9,981.

Interest-only vs. amortizing vs. balloon

These labels describe when principal is repaid, not the size of the loan.

• Fully amortizing: each payment includes principal, and the balance reaches zero at the end of the term. Many commercial loans are not fully amortizing, because the term is shorter than the schedule.
• Amortizing with a balloon: payments are calculated on a longer schedule than the term, so a balance remains at maturity. This is the standard commercial structure, for example a 10-year term on a 25-year schedule.
• Interest-only: for as long as it lasts, none of the principal is repaid. A full-term interest-only loan has a balloon equal to the original loan amount.

Why lenders care

An interest-only period changes the lender's risk in one direction: it delays repayment and makes the borrower rely more on the future refinance or sale. Lenders respond in a few consistent ways.

• They underwrite the amortizing payment. For multifamily loans, Fannie Mae's Multifamily Guide says to calculate underwritten DSCR using the level debt service payment including amortization, whatever the length of the interest-only period. Freddie Mac's Optigo fixed-rate term sheet likewise calculates the DCR for partial-term and full-term interest-only loans using an amortizing payment. An interest-only structure lowers your actual payment; it does not raise the loan amount those lenders will size.
• They may restrict leverage on full-term interest-only. Because no principal is repaid, lenders commonly ask for lower loan-to-value and higher coverage on full-term interest-only than on amortizing loans. Confirm the specific limits with your lender, since they differ by program.
• They test the exit. With a large balance remaining, lenders look at whether the property can support a refinance. See exit strategy and debt yield, which measures income against the loan balance regardless of payment structure.
• Pricing can differ. Ask for interest-only and amortizing quotes side by side rather than assuming the rate is the same.

The practical consequence: if coverage is the constraint, an interest-only period will not fix it. The DSCR a lender tests is often the amortizing one. On the example loan, $113,435 of amortizing debt service at a 1.25x minimum requires about $141,794 of net operating income. The interest-only payment alone would need only about $113,750. A lender who tests on the amortizing payment does not credit that gap. Use the DSCR calculator to run both.

When an interest-only period makes sense

The structure fits when income is expected to rise or capital is going to work harder than the interest it costs:

• Value-add and lease-up. A property being renovated or re-leased has a short-term income dip. Lower payments give the business plan room while NOI catches up.
• Bridge and transition financing. The loan exists to be replaced by permanent financing once the property is stabilized. There is little reason to pay down principal on debt you plan to refinance.
• Construction. Interest accrues only on funds drawn, and the loan converts or is taken out after completion.
• Cash reserved for a better use. Investors sometimes prefer lower payments to fund improvements or other purchases, provided the return on that cash is higher than the loan's rate.

It fits less well when the property is stable and thinly covered, or when the borrower is counting on a refinance that depends on rates and values that may not cooperate. Deferring principal does not remove it. Loans in the maturity wall are the recent example of balances coming due in a different rate and value environment than the one they were written in.

What to watch for and negotiate

• What the payment becomes. Ask what amortization schedule starts when the period ends and calculate the new payment. Stress-test your cash flow at that number, not the interest-only number.
• Length versus term. Ask what percentage of the loan term is interest-only. A short interest-only period on a 10-year loan leaves most of the term amortizing; a long one leaves a large balloon.
• Extension options. Some short-term loans allow extending interest-only periods for a fee if the exit is delayed. Get the fee, conditions and required coverage in writing.
• Rate type. On a floating-rate interest-only loan, the payment moves with the index. Ask about a rate cap and what it costs.
• Prepayment cost. A fixed-rate interest-only loan can carry defeasance, yield maintenance or a step-down penalty. Refinancing early to escape the payment reset can cost more than the payment increase.
• Conversion conditions. Some loans require you to meet coverage or occupancy tests to keep or extend an interest-only period. Read what happens if you miss one.
• Balloon planning. On full-term interest-only, know the date the whole balance is due and what you would need to refinance it. Compare that to your exit strategy.

If you are comparing structures for a specific property, send us the details and we can show the amortizing and interest-only payments side by side, with the coverage each lender would actually test.

Common mistakes

• Treating the low payment as permanent. Budgeting cash flow around the interest-only payment past its end date.
• Assuming a bigger loan. Expecting the lower payment to increase proceeds when the lender sizes on an amortizing payment.
• Ignoring the balance at maturity. Comparing only monthly payments, not the extra principal still owed at the end.
• Forgetting the rate on refinance. A refinance takes place at the rate of the day, not the rate you started with. Your interest-only savings can be consumed by a higher rate at takeout.

Sources: Fannie Mae Multifamily Guide, "Underwritten DSCR" (mfguide.fanniemae.com); Freddie Mac Optigo Fixed-Rate Loans term sheet (mf.freddiemac.com). Example calculations use the site's commercial mortgage calculator arithmetic; the 6.5% rate and $1,400,000 loan are illustrative assumptions, not quotes.