What an interest-only loan does to the balance
On an ordinary amortizing loan, every payment is split between interest on the outstanding balance and principal reduction, and the balance falls from the first month. On an interest-only loan, the payment during the opening period covers the interest and nothing else. The balance you owe at the end of a five-year interest-only period is exactly the balance you borrowed.
That produces a payment which is genuinely small, because it contains no repayment at all. At 6% on $300,000 the interest-only payment is $300,000 × 0.005 = $1,500, against $1,798.65 for a 30-year amortizing loan at the same rate. The gap is not a discount — it is the $298.65 of principal you are not paying, and it is still owed.
The consequence arrives at the reset. The same $300,000 now has to be repaid over the 25 years that remain rather than the original 30, so the payment becomes $1,932.90 — not just above the interest-only figure but above what the loan would have cost had it amortized from the start. That is the structural point: an interest-only period does not remove a payment, it moves it, and it moves it into a shorter window.
Two formulas, one balance
The interest-only payment is the simplest formula in consumer lending: principal times the monthly rate. Divide the annual rate by twelve to get the monthly rate, then multiply by the balance. There is no discounting, no exponent and no term, because nothing is being repaid.
The reset payment is the standard amortized-loan formula, but applied to two adjusted inputs. The principal is the original loan amount, since none of it has been repaid, and the number of payments is n − k: the full term less the interest-only months. Compressing a 30-year repayment into 25 years is what makes the second payment large, and the shorter the remaining window, the larger it gets. A ten-year interest-only period on a 30-year note leaves 20 years, which is why the calculator warns once the interest-only period reaches ten years.
A second effect works in the same direction on adjustable-rate notes: the rate at reset is not the rate at closing. Set the reset rate above the opening rate and both effects compound — a larger payment on a shorter schedule. The example shipped with this calculator, $200,000 at 5% with a ten-year interest-only period resetting to 8%, more than doubles the payment, from $833.33 to $1,672.88, a shock of 100.75%.
Total interest is the two phases added: k months of the interest-only payment, plus everything above principal in the amortizing phase. Comparing that against a loan of the same size, rate and term that amortized from the first payment isolates the cost of the deferral, and it is always positive when the rate is positive, because you carry the full balance for longer.
Worked example: $300,000 at 6%, five years interest-only on a 30-year note
A fixed-rate note of $300,000 at 6%, interest-only for the first five years, fully amortizing over the remaining 25.
- Monthly rate. 6% ÷ 12 = 0.5%, or r = 0.005.
- Interest-only payment. $300,000 × 0.005 = $1,500.00 a month for 60 months. The balance stays at $300,000 throughout.
- Months left to amortize. 360 − 60 = 300.
- Reset payment. Using the amortized-loan formula at 0.005 over 300 months, the factor is 6.44301 per $1,000, so the payment is 300 × 6.44301 = $1,932.90.
- Payment shock. $1,932.90 − $1,500.00 = $432.90, an increase of $432.90 ÷ $1,500.00 = 28.86%, arriving in a single month.
- Total interest. The interest-only phase costs 60 × $1,500 = $90,000. The amortizing phase pays 300 × $1,932.90 = $579,870, of which $300,000 is principal, leaving $279,870 of interest. Total: $369,870.
- The comparison. The same loan amortizing from day one has a factor of 5.99551 per $1,000, a payment of $1,798.65, and total payments of 360 × $1,798.65 = $647,514, of which $347,514 is interest. The interest-only structure therefore costs $369,870 − $347,514 = $22,356 more.
Five years of paying $298.65 a month less — $17,919 of deferred principal — costs $22,356 in additional interest. That ratio is the whole trade, and it is the number to weigh against whatever you did with the cash flow instead.
How to read the result
Qualify yourself on the reset payment, not the opening one. This is the single most important use of the calculator. If the $1,932.90 figure does not fit your budget, the loan does not fit your budget, and the five comfortable years in between change nothing about that. Regulation Z's ability-to-repay rule takes the same view: for a loan with an interest-only feature, the lender must underwrite against the payment that repays the principal over the term, not the introductory one.
Read the payment shock percentage alongside the dollar figure. The percentage tells you how much your housing cost changes overnight; the dollar figure tells you what you have to find. Both are needed. A shock of 28.86% on a moderate payment is easier to absorb than a shock of 15% on a very large one.
Note that a lower rate produces a larger shock. The interest-only payment is proportional to the rate, while the amortizing payment is much less sensitive to it, so the gap between them widens as the rate falls. The reference table below shows this directly: with the same rate before and after, a five-year interest-only period on a 30-year loan produces a 58.35% shock at 4% and an 11.89% shock at 9%. Cheap money makes the interest-only payment look most attractive precisely where the eventual step up is largest.
You build no equity during the interest-only period. The balance is flat, so the only source of equity is the property rising in value. If prices fall instead, you can end the interest-only period owing more than the property is worth with no amortization to have cushioned it. This is the mechanism that made interest-only lending destructive in the mid-2000s, and it is why these loans are excluded from the Qualified Mortgage definition in Regulation Z.
The extra interest is not the whole story. Deferring principal costs money, but the money you did not pay was available for something else. If it earned more than the loan rate after tax, the trade was profitable. If it funded consumption, it was not. Be honest about which happened.
Payment shock per $100,000 borrowed
| Rate | Interest-only payment | Payment for the remaining 25 years | Shock ($) | Shock (%) |
|---|---|---|---|---|
| 4.00% | $333.33 | $527.84 | $194.50 | 58.35% |
| 5.00% | $416.67 | $584.59 | $167.92 | 40.30% |
| 6.00% | $500.00 | $644.30 | $144.30 | 28.86% |
| 7.00% | $583.33 | $706.78 | $123.45 | 21.16% |
| 8.00% | $666.67 | $771.82 | $105.15 | 15.77% |
| 9.00% | $750.00 | $839.20 | $89.20 | 11.89% |
Multiply the first two columns by your loan amount in hundreds of thousands. The 6% row reproduces the worked example: 3 × $500.00 = $1,500.00 and 3 × $644.30 = $1,932.90.
What Regulation Z says about interest-only loans
Two provisions of Regulation Z, which implements the Truth in Lending Act, shape how these loans are made in the United States.
Ability to repay (12 CFR 1026.43(c)). A lender making a closed-end mortgage must make a reasonable, good-faith determination that the borrower can repay it, and for a loan with an interest-only feature that determination uses the payment that would repay the principal over the loan's term — not the introductory interest-only payment. Underwriting on the smaller figure is precisely what the rule forbids.
Qualified Mortgage status (12 CFR 1026.43(e)). A Qualified Mortgage may not have an interest-only feature, so these loans sit outside the QM safe harbour. That does not make them unlawful; it means they are made outside the standard framework, generally by portfolio lenders, often to borrowers with irregular income or substantial assets.
Neither provision applies to business-purpose lending, which is why interest-only and bridge structures remain common in commercial and investment property finance where the rule does not reach.
Assumptions and limits of this calculation
- Principal and interest only. Property tax, homeowners insurance, HOA dues and mortgage insurance are excluded. On a real mortgage these can add a quarter or more to the payment — the mortgage payment calculator includes them.
- A single reset. Adjustable-rate loans typically reset periodically after the first adjustment, with periodic and lifetime caps. This model applies one rate for the interest-only period and one for the rest. Run it again at the lifetime cap to see the worst case the note permits.
- No balloon. The whole principal is assumed to amortize over the remaining term. Some interest-only notes, particularly bridge and construction loans, instead require the entire balance at maturity — if the interest-only period equals the term, the calculator says so.
- No extra payments. Paying principal voluntarily during the interest-only period reduces both the balance and the reset payment. Most interest-only notes permit it; check for a prepayment penalty first.
- Exact monthly periods. Interest is charged on a monthly basis with no day-count adjustment, which matches how residential mortgages are administered but not how every commercial note is written.
- The note rate, not the APR. Entering an APR that includes fees will not reproduce your actual payment, because the APR is a comparison figure computed on a different basis.
When an interest-only structure earns its place
Interest-only lending has legitimate uses, and they share one feature: a specific, funded plan for the principal that does not depend on the borrower's monthly cash flow.
Bridge finance. You are buying before selling and will repay the whole balance from the sale proceeds within months. Interest-only keeps the carrying cost minimal while both properties are held, and the exit is a lump sum rather than a schedule.
Genuinely irregular income. A borrower paid largely in annual bonuses or realised gains can carry a low fixed monthly obligation and pay principal in lumps when the money arrives. This only works where the lump payments actually happen; the discipline has to be real rather than intended.
Investment property. An investor holding a rental for a defined period may prefer the higher net cash flow, accepting the interest cost as the price. The arithmetic is a straightforward comparison between the loan rate and the return on the deferred principal.
Drawing lines of credit. A home equity line of credit is interest-only by construction during its draw period and then amortizes, which is exactly the structure modelled here — the HELOC payment calculator handles the variable balance a draw period involves.
What all of these have in common is that the borrower is buying flexibility, not affordability. Using an interest-only period to reach a house that the amortizing payment could not have reached is the failure mode, and it is the one the ability-to-repay rule exists to prevent. If affordability is the question, answer it with the home affordability calculator against the fully amortizing payment, and if you want to see how much faster a conventional loan retires the balance, compare the schedules with the amortization schedule calculator.