Interest only loans made headlines in recent years for their role in the housing crisis. While they are most commonly used to finance real estate, interest only loans can be used to finance the purchase of any asset that appreciates over time. Interest only loan payments differ from standard loan payments because they do not reduce the outstanding loan balance. Calculating the payment on an interest only loan involves multiplying the loan balance by the periodic interest rate.
A Brief History of Interest Only Loans
Interest only loans are not an invention of modern finance. As a matter of fact, a version of the interest only loan, known as a term loan, was the standard lending model used for financing residential real estate until the Great Depression. In recent years, interest only loans allowed buyers to purchase real estate during a time of extraordinary price growth. Buyers who could not qualify for traditional loans with a large down payment could finance their purchase with an interest only loan and later refinance, once the price appreciation created a sufficient equity stake in the property.
Calculating an Interest Only Loan Payment
To calculate the monthly payment on an interest only loan, simply multiply the loan balance times the monthly interest rate. The monthly interest rate is the annual interest rate divided by twelve. For example, an interest only payment on a $300,000 loan at an annual interest rate of 6% is calculated as follows:
Interest Only Payment = loan balance x (annual interest rate/12) Interest Only Payment = 300,000 x (.06/12) Interest Only Payment = 1500
Notice that the term of that loan does not affect the loan payment.
Calculating a Standard Loan Payment
A standard loan payment calculation amortizes the original loan amount over the term of the loan. A standard loan payment includes a portion of the payment to cover the interest due on the loan and another portion of the payment is used to decrease the loan principal. For example, a $300,000 loan over 30 years with a 6% annual fixed interest rate has a monthly payment equal to $1798.65.
Month 1: Standard Loan Payment = Interest + Principal $1798.65 = $1500 + $298.65
As shown above, in the first month there is $1500 of interest due on this loan. Every dollar above $1500 will pay down the outstanding principal balance on the loan. Making this payment will decrease the outstanding loan balance, so the interest portion of the payment will be less than $1500 after the first month. As a result, the portion of the payment applied to principal increases every month.
What Is the Difference?
There are two important differences between interest only loan payments and standard loan payments:
When borrowing the same dollar amount at the same interest rate, the standard loan payment will always be higher than the interest only payment
Interest only loan payments never decrease the outstanding loan balance. The payment only covers the interest due. Standard loan payments decrease the loan balance every month until reaching a balance of zero at maturity.