Interest-only loans: formulas, mechanics, and what to watch for

An interest-only loan is a loan structure where, for a defined initial period, your required payment covers only the interest that accrues on the balance. The loan can be a mortgage, a business loan, or a private loan. The defining feature is that your balance typically does not decline during the IO window—unless you voluntarily pay extra principal. That’s why an interest-only loan can feel “cheap” month-to-month but still be expensive over the life of the loan.

The two questions that matter most are: (1) What is the payment during the interest-only phase? and (2) What happens when the IO phase ends? This calculator answers both and adds a third: How does the total interest compare to a fully amortizing loan?

The interest-only payment is straightforward: Interest-only payment = Principal × periodic interest rate. The periodic rate depends on the payment frequency. For monthly payments, the periodic rate is APR ÷ 12. For biweekly, it’s APR ÷ 26. For weekly, it’s APR ÷ 52.

Example: $300,000 at 6.5% APR monthly: periodic rate = 0.065 ÷ 12 = 0.0054167. Interest-only payment = 300,000 × 0.0054167 ≈ $1,625 per month. If you make only that payment, your balance stays close to $300,000 for the entire IO term.

The balloon is what you still owe when the IO term ends. If you never paid extra principal, the balloon is essentially your original principal. If you did pay extra principal, the balloon is smaller. That balloon drives your future risk: it determines whether you can refinance, whether you have enough equity, and how large your payment becomes if the loan converts to amortizing.

Real-life catch: Many borrowers assume “I’ll just refinance.” That can fail if rates rise, income drops, or the property value falls. Always treat refinancing as a possibility—not a guarantee.

Most interest-only mortgages convert to amortizing payments after IO ends. But here’s the twist: you’re paying down the remaining balance over a shorter remaining term. A 30-year loan with a 5-year IO period leaves only 25 years to amortize the balance. The payment must be higher than a normal 30-year amortizing mortgage, because the principal has to be repaid in fewer months.

The standard amortizing payment formula (PMT) for a fixed rate loan is: PMT = P × r ÷ (1 − (1 + r)⁻ⁿ), where P is principal, r is periodic interest rate, and n is number of remaining payments. This calculator uses that formula to compute your post-IO payment if the loan converts.

Total interest is where interest-only loans can surprise people. When principal stays higher for longer, you pay more interest for longer. A fully amortizing loan reduces principal every payment, which gradually reduces interest. Interest-only loans delay that principal reduction, often increasing total interest—unless you pay extra principal early.

This calculator shows total interest for: (A) Interest-only structure: interest accrued during IO + interest during the remaining amortizing period, plus (B) Fully amortizing structure: amortizing from day 1 over the full term. The difference helps you judge whether the “lower payment now” is worth the “higher cost later.”

• Scenario A: Extra principal = $0 (baseline)
• Scenario B: Extra principal = $200 (moderate risk control)
• Scenario C: Extra principal = $500 (aggressive balloon reduction)

If Scenario A produces a balloon and post-IO payment that scares you, you have a real signal: either you need to pay extra principal, choose a different loan, or avoid the IO structure entirely.

Frequently Asked Questions

• Is interest-only “bad”?

  No—it's a tool. It can be useful for cash flow, but it increases risk if you’re counting on refinancing or price appreciation.

• Does extra principal change my IO payment?

  Yes. Interest is calculated on the current balance. If you reduce the balance with extra principal, future interest-only payments shrink.

• What if my lender calculates interest differently?

  Some loans use daily interest or different compounding. This calculator uses a standard periodic-rate model for clear comparisons.

• Does this include escrow, PMI, or fees?

  No. This models principal-and-interest only. Taxes, insurance, and other fees can be added on top by your lender.

• How can I reduce risk with an IO loan?

  Keep liquidity, pay extra principal during IO, and make sure you can afford the post-IO payment under worse-case scenarios.

• Can you afford the post-IO payment if you don’t refinance?
• Do you have a plan for the balloon balance?
• Have you stress-tested a higher rate (if adjustable) and a lower property value?