Definition
Interest-only (IO) is a loan payment structure where the borrower pays only the interest on the outstanding principal balance for a set period, with no required principal amortization during that time. After the IO period ends, payments usually increase because the loan begins amortizing (or the balance becomes due at maturity).
Where Interest-Only Is Common
- Bridge loans: value-add acquisitions during renovation and stabilization.
- Construction loans: interest is typically paid on drawn funds during construction.
- Agency or permanent loans: sometimes offer partial IO terms (e.g., first 1–5 years IO).
- CMBS / debt funds: may structure IO to maximize cash flow during the business plan.
How IO Payments Work
During the interest-only period, the payment is calculated on the outstanding principal balance:
Common formula
- Monthly IO Payment = Loan Balance × (Annual Interest Rate ÷ 12)
Why Investors Use Interest-Only
IO periods reduce near-term debt service, which can increase free cash flow and improve debt service coverage during renovations, lease-up, or early operations. This can be helpful when NOI is temporarily depressed and the business plan needs time to mature.
Tradeoffs and Risks
Interest-only is not “free money.†It changes the timing of principal repayment and increases reliance on the property’s ability to refinance or sell.
Key risks
- Payment shock: when IO ends, payments often rise because amortization begins.
- Refinance risk: if the loan matures without principal paydown, you may need a refi in a worse rate or credit environment.
- Higher leverage exposure: lack of amortization means the loan balance stays high, increasing sensitivity to cap rate expansion.
- Exit dependency: the plan may rely on selling or refinancing at a specific time.
Underwriting Considerations
- Model the step-up: explicitly switch from IO to amortizing payments when the IO period ends.
- Stress DSCR: run DSCR tests during IO and after IO (the “real†stabilized payment matters).
- Match IO to the business plan: IO should cover renovation/lease-up, not just boost projections.
- Watch covenants: some lenders require DSCR or debt yield milestones after stabilization.
- Consider extension fees: bridge IO loans often have extension options with costs and conditions.
Example
A borrower takes a $10,000,000 loan at 6.6% interest with a 24-month interest-only period.
- Monthly IO Payment = 10,000,000 × (0.066 ÷ 12) = $55,000
If the loan later converts to a 30-year amortization at the same rate, the monthly payment would increase materially because it now includes principal. If NOI does not grow as planned, the property may fail DSCR when amortization starts.
Common Pitfalls
- Underwriting to IO forever: assuming the lower payment persists can inflate cash-on-cash and IRR.
- Not modeling draw schedules: construction loans accrue interest on drawn balances, not full commitment.
- Ignoring capex reserves: IO can make cash flow look strong while deferring needed reinvestment.
- Extension assumptions: treating loan extensions as guaranteed without meeting lender conditions.
- Exit cap optimism: high loan balance + cap rate expansion can wipe out sale proceeds.