Mortgage permitting scheduled payments that cover interest but no principal for a defined period.
An interest-only mortgage permits scheduled payments that cover the interest due but do not require principal repayment for a defined period. When that period ends, the payment structure changes, the loan becomes due, or another contract feature addresses the remaining balance.
The interest-only payment can be materially lower than the payment needed to amortize the same balance. That may provide short-term cash-flow flexibility, but it postpones principal reduction and can create a later payment increase.
If no extra principal is paid, the balance generally remains unchanged during a true interest-only phase because the required payment covers all scheduled interest and none of the principal. The borrower therefore builds no equity through scheduled principal reduction during that phase.
The later payment may need to repay the same balance over fewer remaining years. If the loan also has an adjustable rate, a rate increase can combine with the shorter amortization period and intensify payment shock.
Borrowers encounter the feature while comparing nonstandard mortgage products and reviewing projected payments. The Loan Estimate and Closing Disclosure identify payment changes, while the note states the interest-only end date and what happens afterward.
Before closing, identify:
The opening payment is only one phase of the loan.
For a simplified fixed-rate example with monthly interest calculations:
$$ \text{Monthly interest-only payment} = \frac{\text{principal balance} \times \text{annual note rate}}{12} $$
For a $400,000 balance at 6.00%:
$$ \frac{$400{,}000 \times 0.06}{12} = $2{,}000 $$
That $2,000 covers one month’s interest in the simplified example but does not reduce the $400,000 principal. Taxes, insurance, mortgage insurance, fees, and different interest conventions are not included.
When the interest-only period ends, the required principal-and-interest payment is based on the outstanding balance, applicable rate, and remaining repayment period. The result can be substantially higher even if the rate has not changed.
| Phase | Scheduled payment effect | Principal balance effect |
|---|---|---|
| Interest-only period | Covers scheduled interest | Generally remains level if paid as agreed |
| Amortizing period | Covers interest and scheduled principal | Declines toward payoff |
| Balloon maturity, if present | Remaining amount becomes due | Must be paid, sold, or refinanced |
The contract may combine these features differently. Interest-only does not by itself prove that the loan has a balloon or an adjustable rate.
A borrower takes a 30-year mortgage with a five-year interest-only period followed by 25 years of fully amortizing payments. During the first five years, the required payment covers interest and the scheduled balance does not decline.
At the end of year five, the remaining principal must be amortized over 25 years rather than 30. The payment rises because principal repayment begins over the shorter remaining period. If the rate also resets at that time, the increase can be larger.
Interest-only mortgage differs from a Fully Amortizing Mortgage because fully amortizing payments include enough principal to reach zero by maturity from the start of the applicable schedule.
It differs from Negative Amortization because a true interest-only payment covers all scheduled interest. A negatively amortizing payment covers less than the accrued interest, allowing unpaid interest to increase the balance.
It differs from an Adjustable-Rate Mortgage (ARM) because interest-only describes payment structure, while ARM describes rate behavior. A mortgage can have either feature or both.
It also differs from a Balloon Mortgage. An interest-only loan may later fully amortize, while a balloon structure requires a large remaining amount at maturity.