What is an Interest-Only Loan?

Malcolm Tatum
Malcolm Tatum

An interest-only loan is a type of loan arrangement that defers the payment of the principal amount until the due date at the end of the loan contract. In the interim, the borrower makes payments on the interest accrued, usually on a monthly basis. This type of loan arrangement is sometimes used in the structuring of mortgage financing or even in the extension of personal loans. The interest-only loan format is widely available in many nations across the globe, although banking laws in some nations, notably Canada, do not provide for the extension of this particular loan product.

Man climbing a rope
Man climbing a rope

With an interest-only loan, the lender arranges to extend a specific amount of money to the borrower, with a due date attached to the loan. The rate of interest is also identified in the terms of the loan agreement, including whether the rate is fixed or floating. As part of the arrangement, the lender agrees to defer payments on the principal amount of the loan until the due date. At the same time, the borrower agrees to make scheduled payments that settle the interest applied to that principal. The end result is that by the time the loan is due, all the interest for the debt has been settled, and the borrower must then repay the principal amount borrowed on the date identified in the loan contract.

There are a couple of benefits associated with this type of loan arrangement. Since the payment of the principal is deferred, borrowers who anticipate an influx of cash just before the due date can use this strategy to borrow the money up front, use it in some type of revenue generating project, then settle the loan in full by the due date. As an example, an entrepreneur may open a new business location using proceeds from an interest-only loan. The lower interest payments are made monthly, providing the business time to build a clientele and begin to turn a profit. Assuming that the business is firmly established and consistently generating profits when the due date on the interest-only loan arrives, the entrepreneur settles the remaining balance on the loan with relatively little difficulty.

Lenders can also benefit from the interest-only loan offering, since loans of this type provide a steady flow of return on the investment. Typically, the interest payments are scheduled monthly, although there are situations in which the payments are set for quarterly or even semi-annually. This allows the lenders to know when to expect returns to arrive, and when the principal will be repaid, making it possible to use available resources to best advantage and issue additional loans to other customers.

In many instances, there is nothing to prevent borrowers from retiring balances on interest-only loan contracts early if they so desire. Depending on the business practices of the lender, it may be necessary to settle the interest before any additional payments are applied to the principal. Some lenders will allow borrowers to make the interest payment currently due, then designate any amount over the regularly scheduled payment to be applied to the principal. The terms and provisions found in the loan contract will provide specific information regarding early retirement of the debt, and the process for applying advance payments to the principal prior to the due date.

Malcolm Tatum
Malcolm Tatum

After many years in the teleconferencing industry, Michael decided to embrace his passion for trivia, research, and writing by becoming a full-time freelance writer. Since then, he has contributed articles to a variety of print and online publications, including wiseGEEK, and his work has also appeared in poetry collections, devotional anthologies, and several newspapers. Malcolm’s other interests include collecting vinyl records, minor league baseball, and cycling.

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