An interest-only period on a loan is a specified timeframe during which the borrower is required to pay only the interest on the loan, without making any principal repayments. This means the monthly payments are lower compared to a standard loan repayment schedule that includes both principal and interest.

The interest-only period can vary in length, commonly ranging from a few months to several years, depending on the loan agreement. After the interest-only period ends, the borrower typically enters a repayment phase, where they start paying both interest and principal, resulting in higher monthly payments.

This structure can be beneficial for borrowers in specific financial situations but also has implications for the overall cost of the loan and long-term financial planning.

Benefits

• Lower initial payments. Borrowers benefit from reduced monthly payments during the interest-only period, which can help with cash flow management, especially in the early stages of a project or investment.

• Flexibility. This structure can provide flexibility for borrowers who expect their income to increase in the future or who plan to sell the property or investment before the principal payments begin.

Risks

• Larger payments later. Once the interest-only period ends, the borrower will face higher monthly payments as they begin to pay down the principal. This can lead to payment shock if not properly planned for.

• Potential for negative amortization. If the loan has a balloon payment or if the interest payments do not cover the accruing interest, the principal balance could increase, leading to negative amortization.

Borrowers should carefully consider their financial situation and long-term plans when opting for a loan with an interest-only period.