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Understanding Interest-Only Loans vs. Amortizing Loans

Guide published by Jose Abuyuan on February 18, 2020

When it comes to loans, you'll notice many types of consumer finance follow a traditional payment schedule called amortization. This payment schedule tells you how much of your money goes toward your loan's interest and principal balance. It is also applied from start to finish of your loan. Amortization ensures your balance is reduced to zero by the end of your loan term.

However, did you know there are loans that allow you to make interest payments during the first few years? These are referred to as interest-only loans.

In this article, we'll discuss what interest-only loans are and how they compare with amortizing loans. We'll also talk about its benefits and disadvantages, and whether this payment option can work for you.

What are Interest-Only Loans?

Coins with growing interests

Interest-only loans come with an initial payment duration that only requires interest payments for a specified amount of time. Most interest-only loans also have variable rates, which means the interest rate changes as soon as the interest-only period is done. Under this arrangement, borrowers can defer the full loan amount while only paying for the cost of borrowing money during the first few years.

Interest-only loans are ideal for individuals with stable incomes, including:

  • People with irregular but large income streams such as small business owners
  • People with high net worth looking to borrow money and take advantage of their liquidity
  • College graduates anticipating a higher income

This type of loan imposes a fixed interest during the initial payment period, which also means lower monthly payments during the early years of the loan.

Pigly's Tip!

Take advantage of the low monthly payments. You can make significantly higher payments during the interest-only period of your loan. Paying more greatly reduces your loan's principal, which means less interest accrues over the life of the loan.

Interest-only loans can be found in different consumer finance options such as the following:


Interest-only mortgages are used by consumers with high net worth to maximize their capital use. For people who want to buy and sell a house, the low initial payments allow them to afford short-term homes and place their money on income-generating investments. If your goal is to sell an expensive house before the end of the interest-only period, there's an option to end your contract early by refinancing to a conventional mortgage or selling the house. Doing so allows you to pay a lumpsum balloon payment on the loan, which helps you dodge extra interest costs. 

Home Equity Lines of Credit (HELOC)

HELOC allows you to borrow money against the equity you've built in your home. Once you pay down a significant percentage of your mortgage, which is typically around 80 percent, you can have access to home renovation funds through HELOC. You are given a ‘draw period' to take credit. During this time, you are only required to pay interest on the credit you use. But take note that most HELOCs have variable interest rates, which means the standard interest rate may increase or go down. Once the draw period is over, your payment schedule shifts to an amortized schedule. This assures the lender that you'll keep paying back the money you owe.

Student Loans

Student loans are actually a type of interest-only loans. Interest accumulates in private student loans and unsubsidized federal loans. While payments are not required when a student is still studying, interest that accumulates during this period capitalizes. This means the interest is added on top of your original loan balance, which makes your student loan accrue more interest. To steer clear of interest capitalization, you can make interest payments to your lender while still in school.

How the Interest-Only Payment Structure Works

For instance, under an interest-only mortgage, borrowers are required to make payments on the loan's interest within a set period. Once this interest-only period is done, your monthly mortgage payment shifts to become an amortized loan.

Qualifying for Interest-Only Mortgages

To be eligible, your credit score must range between 720 to 740. Borrowers must have a debt-to-income ratio of 43 percent and should make at least 20 percent down payment on the property.

How long does the interest payment period last? It generally runs for 5 or 10 years for mortgages. For other types of loans, it can last for 3 years or as long as 20 years. During this payment period, you have the freedom to increase your payments, with the remainder of the amount going toward your principal balance.

After this payment duration, borrowers usually have the entire loan term, which is typically around 10 or 20 years to pay down the principal balance and any accrued interest. However, if you want to pay down your mortgage debt sooner, you can choose to pay your principal in full. Other homebuyers choose this type of loan to gain home equity faster.

Interest-only mortgages are similar to adjustable-rate mortgages (ARM). During the interest payment period, your loan's interest rate is fixed. ARMs also start off with fixed-rate payments. Once this duration ends, your interest rate increases as time goes by.

Interest-Only Loans vs. Amortized Loans

Pig on top of a calculator

Every loan has two main components: the principal and the interest. The principal is the amount you owe the lender, while the interest is the money the lender charges to service your loan. With interest-only loans, you only pay for the interest during the first several years of your debt. By the end of this initial payment period, the Consumer Financial Protection Bureau (CFPB) states you have the following options:

  • You can pay down the loan balance at once.
  • You can start to pay off the balance in monthly installments (it starts to amortize), which has a higher interest rate compared to the initial payment period.
  • You can refinance your loan if this opportunity is an option.

On the other hand, traditional mortgages immediately apply amortization on your first payment. A portion of your payment goes toward the interest and the principal balance every month. These payments are arranged periodically with a definite end date, ensuring your debt is reduced to zero. Amortization applies whether you choose a fixed-rate loan or adjustable-rate loan.

Over time, the more payments you make, the payment ratio for interest and principal changes. For example, if you have a 30-year mortgage with a large principal and high interest, the principal payment ratio increases significantly toward the latter years of the loan term, while the interest ratio decreases.

To illustrate how different they are, let's take a look at the difference between a traditional amortizing loan and an interest-only loan. Let's use the mortgage details below with a 10-year interest-only period.

Need to compare an amortizing loan with an interest-only loan? Use our calculator on top of this page.


  • Loan amount: $200,000
  • Interest rate: 5%
  • Loan term: 30 years
Loan Details Traditional Amortized Loan Interest-Only Loan
Interest-only monthly payment $833.33 (first 10 years)
Fully Amortized monthly payment $1,073.64 $1,320.57
Overall interest cost $186,511.57 $300,000
Overall cost of the loan $386,511.57 $500,000

In the above table, your monthly mortgage payment will cost $1,073.64 with an amortizing loan. That's a fixed amount for 30 years. With an interest-only mortgage, the monthly payment will only cost $833.33 for the first 10 years. But after this period, your monthly payment can increase as high as $1,320.57.

For the overall interest, the amortized loan will cost $186,511.5, while the interest-only loan will cost $300,000. In total, you will spend $386,511.57 for an amortized mortgage versus $500,000 for an interest-only mortgage. That's a difference of $113,488.43 in savings.

This example shows that payments for the first 10 years in the interest-only loan is more affordable. However, borrowers must be prepared for high monthly payments afterwards. If you think you cannot make increased payments in the future, do not choose this type of loan.

If you want to avoid the high interest cost, you can pay down your principal in full once the interest-only period ends. Make sure you have enough funds to cover the large payment.


If you cannot afford higher payments based on your current income, obtain a traditional mortgage instead. Once your payment gets higher, your financial capabilities may change. This puts you at greater risk of default. Your property's value could also depreciate. Refinancing your loan or selling your property may not always be available options once your payments become higher.

Shifting a Revolving Credit Source to an Amortizing Payment

Money time credit card

How about revolving credit payments versus amortized payments? Revolving credit, such as credit cards, are not issued with a preset amount. It only puts a cap on how much you can borrow. That means the amount you decide to withdraw within the limit is entirely up to you. Many revolving loans are offered as lines of credit. This allows a borrower to charge and pay off the amount as they continue to make charges. But beware. Unsecured revolving credit can take 15 to 20 percent interest. The flexibility to borrow more money often racks up higher interest costs. In a similar manner, adjustable-rate mortgages (ARM) and interest-only loans tend to cost more when interest rates rise.

Meanwhile, amortized loans, also referred to as installment credit, require a definite loan amount and payment time. These factors determine your monthly payment. Common amortized loans are mortgages and car loans. Because the amount is predetermined, the sum you borrowed does not change with time.

If you're starting to incur more debt than you are able to pay, it's time to stop charging from revolving credit. You should seriously stop using your cards if you're racking up multiple debt. When this happens, you can take out an amortizing loan, like a personal loan, and consolidate your debt. Likewise, you should consider shifting an ARM or interest-only loan to an amortized loan if you think you cannot afford the high payments caused by rising interest rates. This move makes sense when interest rates are low, so you can secure a favorable fixed rate.

For revolving credit like HELOC, you are allowed to convert a portion of your balance to a fixed rate with a specified term. This can be done during the draw period, which should help manage your payments.

How will shifting to an amortizing payment help? One, you'll have the benefit of predictable monthly payments that are easier to budget and track. The fixed loan amount also ensures the principal balance does not increase. Second, amortized loans usually have lower interest rates (2 percent for secured loans and up to 18 percent for unsecured loans) than credit cards. This means you can lower the interest rate if you use a personal loan to consolidate your credit card debt.

The Pros and Cons of Interest-Only Loans

Pros Cons
Allows affordable payments for the first several years of the loan. Interest-only loans generate high interest cost, especially in the long term.
You can pay a higher amount during the initial payment period to significantly decrease your principal balance. “Payment Shock” – Once the initial payment period ends, your monthly amount can get really expensive.
For mortgages up to $750,000, the entire amount of the monthly payment is tax-deductible during the initial payment period. For mortgages, your home may not appreciate as quickly as you would like.  
It allows high-income borrowers to maximize short-term capital and increase their net worth. Your income may not increase as you expect it. If you cannot afford the higher payment, it puts you at greater risk of default.

Take Advantage of the Benefits  

Interest-only loan options allow consumers to reduce the initial costs of borrowing money. With traditional amortized loans, you make payments that cover both the interest and principal. But with interest-only loans, your payments can work in two ways:

  • The first option delays your amortization schedule, allowing you to cover only the interest cost.
  • The second option lets you make interest-only payments during the early years of the loan, then allows you to make a lumpsum payment to pay down your principal balance.

Borrowers can make the most out of lower monthly payments to pay down their debt. This helps them rebuild savings after covering the down payment and closing costs. And under mortgage interest tax deductions, it is possible to write off your entire loan payments during the interest-only payment period.

The Rewards of Paying Your Debt in Full

With interest-only loans, it's more advantageous to pay your principal down once the initial payment period ends. This saves you thousands of dollars in interest cost and helps you acquire home equity faster. On the other hand, the higher interest rate and monthly payments can put you in further debt and eat away your savings.

Without the added expenses, you have money to set aside for other important things, such as capital for a new business venture, your child's college tuition, and even your retirement. Moreover, getting your debt paid sooner lowers your debt-to-income ratio. This improves your credit score, which helps you qualify for future loans.   

Watch Out for the Drawbacks

Once the interest-only period ends, your monthly payment increases considerably. This is because the adjustable interest rate at the latter part of the loan is usually higher than its fixed-rate counterpart. Consequently, if the new amount is too high, you have greater risk of defaulting on your loan.

What does this tell us? While pushing back repayment keeps monthly payments affordable, it actually costs a lot more than amortized loans. Thus, it is not a practical option if you need to make sure you can afford long-term loan payments. This type of loan is more suited for borrowers with high-income and a steady stream of funds.

Making Smart Financial Decisions

Monopoly pigly guy

Knowing the benefits and disadvantages of interest-only loans can help you decide whether it's a good payment option aligned with your goals. It helps you defer full payments for several years until you can afford to make the full monthly payments.

Moreover, if you want to gain home equity much faster, it allows you to pay down the principal after the initial payment period ends. For others looking to buy and sell property within a short period of time, interest-only loans can also work for you.  

Finally, one of its great benefits is the opportunity to write off your entire mortgage payments during the interest-only period. You can make really large payments that can help reduce your principal. Just beware of the high interest rates once the initial pay period is over. Make sure you have enough money to afford your loan.

Need to know how bi-weekly loan payments can work for you? Use our calculator and read our guide.

About The Author

Jose Abuyuan is a web content writer, fictionist, and digital artist hailing from Las Piñas City. He is a graduate of Communication and Media Studies at San Beda College Alabang, who took his internship in the weekly news magazine the Philippines Graphic. He has authored works professionally for over a decade.

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