How Do Interest-Only Loans Work? A Simple Guide For Smart Buyers

If you’re in the market to buy a home and you’re not planning to pay cash, chances are high that you’ve either already spoken with a lender or you’re planning to do so in the near future. While there may be limited wiggle room with your budget and credit history, your lender is a valuable resource when it comes to determining an effective loan strategy for the purchase of your new home.

There are numerous types of loans and financing programs available, but today we’re focusing on one that is perhaps lesser-known and certainly harder to find: the interest-only mortgage loan.

With expert advice from Richie Helali, a mortgage specialist at HomeLight, we’re taking a deep dive into the world of interest-only loans — from how they work, to who they’re right for, and everything in between.

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What is an interest-only mortgage, and how does it work?

Put simply, this is a mortgage where you’ll only pay interest for the first several years. This introductory period is usually either 5 or 10 years, and your monthly payments will be significantly smaller during this time.

Interest-only loan calculators are readily available online, often provided by banks, mortgage companies, or financial planning websites. Trusted sources like Chase, Bankrate, or Investopedia offer calculators designed specifically for interest-only loans, with user-friendly interfaces and clear breakdowns of payment results.

By using an interest-only loan calculator, borrowers can learn how to calculate payment on interest-only loans, make more informed decisions about whether this type of loan aligns with their financial goals, and see how it fits into their budget — both now and in the future.

As an example, let’s say you’ve borrowed $250,000 at an interest rate of 3.75%. On a 30-year, fixed-rate loan with an interest-only period of five years, your payment would be $781.25 per month for those first five years. Once the principal payment kicks in, your payment would then go up to $1,285.33 each month for the remaining 25 years of the loan.

Interest-only mortgages are usually adjustable-rate loans. So, while you’ll still have those first years of only having to pay interest, once that period is over, your interest rate will adjust — at the same time, you’ll also start paying toward the mortgage principal.

“Let’s say yours happens to be a 30-year loan, with the first 5 years interest-only. After those 5 years, it goes to a 25-year interest and principal, with a fully adjustable rate,” explains Helali. “The rate is typically going to adjust at least once a year on the anniversary of the loan. It could go up by $X amount; it could go down by $X amount.”

If an adjustable rate sounds a little scary, don’t fret — there’s going to be a rate cap that you will have agreed to at the time of the loan, and it’ll protect your monthly payment from skyrocketing.

As the OCC explains, “If your loan has a payment cap of 7.5%, your monthly payment won’t increase more than 7.5% from one year to the next, even if interest rates rise more than 7.5%.“

Do be aware, though, that this rate cap merely caps your actual monthly payment. You’re not off the hook for the additional interest. Whatever interest you don’t pay as a result of your payment cap will be added to the balance of the loan.

This means that you’ll probably prefer a fixed-rate interest-only loan; just don’t count on finding one at the drop of a hat.

According to Helali, they’re extremely uncommon.