Interest-Only Loans vs Repayment Mortgages: Payments, Risks, and End of Term
An interest-only loan asks for the smallest possible monthly payment — interest and nothing else — and in exchange it asks for the largest possible reckoning at the end. The balance never falls, the equity never grows from payments, and the entire principal comes due at once. This guide compares that bargain honestly against a repayment mortgage, with numbers, so you can see what cheap monthly payments actually cost.
Key takeaways
- Interest-only monthly payment = loan balance × annual rate ÷ 12. On a $400,000 loan at 6%, that is $2,000 a month — and the balance after 10 years is still $400,000.
- A repayment mortgage at the same rate and term costs more monthly ($2,398 on a 30-year term) but ends with the home owned outright; the interest-only borrower still owes the full $400,000.
- The three honest tests before taking an interest-only loan: a credible repayment plan for the principal, tolerance for rate rises on the full balance, and an exit that does not depend on house-price growth.
How the payments work
An interest-only payment covers exactly one month’s interest on the outstanding balance and reduces the principal by zero. The formula is as simple as the product:
Monthly interest-only payment = loan balance × annual interest rate ÷ 12
On a $400,000 loan at 6%: $400,000 × 0.06 ÷ 12 = $2,000 per month. On a $300,000 loan at 7%: $300,000 × 0.07 ÷ 12 = $1,750 per month. Because the balance never changes, the payment never changes either — until the rate changes, at which point the payment moves in lockstep on the full original balance. A repayment mortgage payment, by contrast, is computed from the standard amortisation formula and includes a growing principal slice each month; early payments are mostly interest, but the principal slice grows every month until the loan amortises to zero.
Run both structures on your own numbers with the interest-only loan calculator before comparing offers: the monthly difference looks like a saving, and only the end-of-term balance reveals what it costs.
Side by side: the same loan, two structures
| Interest-only (10 years, then repay) | Repayment (30-year fixed) | |
|---|---|---|
| Loan | $400,000 at 6% | $400,000 at 6% |
| Monthly payment | $2,000 | $2,398 |
| Balance after 10 years | $400,000 | About $335,500 |
| Balance after 30 years | $400,000 (if never repaid) | $0 |
| Total interest over 30 years | $720,000 (if interest-only throughout) | About $463,400 |
The comparison is stark. The interest-only borrower pays $398 less per month for 30 years and ends up owning nothing more than at the start, having paid about $256,600 more in total interest. The “saving” was never a saving; it was deferred principal, rented at 6% for three decades. Shorter interest-only periods are less extreme — five years interest-only followed by 25 years of repayment is a common hybrid — but the arithmetic always points the same way: every month of interest-only is a month the balance does not fall.
Who interest-only actually suits
Interest-only is not always a mistake. It suits borrowers with irregular income who want low required payments and make lump-sum principal payments when income arrives — provided they actually make them. It suits short-term holders who will sell or refinance well before the interest-only period ends and who have a realistic view of sale costs and market risk. It suits some investors who prefer to keep cash in higher-returning assets than home equity — a genuine strategy, but one that requires the alternative return to reliably beat the mortgage rate after tax, which is a higher bar than it sounds.
It does not suit borrowers who choose it only because the repayment payment is unaffordable. If you cannot afford the repayment payment, you cannot afford the loan at that price — interest-only does not make the home affordable, it makes the unaffordability arrive later, larger, and all at once.
The risks, stated plainly
Rate risk on the full balance. A repayment borrower’s balance falls over time, so a rate rise hits a shrinking number. An interest-only borrower’s balance never falls, so a rate rise from 6% to 8% on $400,000 lifts the payment from $2,000 to $2,667 — a 33% jump with no warning beyond the rate notice.
Negative equity risk. With no principal repaid, any fall in house prices puts the borrower underwater immediately. A 10% price fall on a $400,000 home leaves a $360,000 property securing a $400,000 loan, which blocks refinancing and traps the borrower on whatever rate the lender then offers.
Refinancing risk. Interest-only periods end. At that point the borrower must repay, refinance, or convert to repayment — all of which require the lender’s agreement, which requires income, credit, and equity to still be in good shape. Borrowers who assume refinancing will be available are assuming the future looks like the present.
End of term: the reckoning
At the end of an interest-only term, the full principal is due. The realistic exits are: repay from savings or investments (which must have been built deliberately, not hoped for); sell the property (which must cover the balance plus selling costs — on a $400,000 loan, roughly $24,000–$40,000 of costs at typical commission levels, so the sale must clear about $430,000 just to break even); refinance into a new loan (subject to income, credit, equity, and market conditions); or convert to a repayment mortgage with the same lender (which raises the payment sharply — converting $400,000 at 6% to a 20-year repayment lifts it from $2,000 to about $2,866).
Every one of those exits should be written down, with numbers, before signing. “The house will be worth more” is not a repayment plan; it is a forecast, and forecasts are not accepted as payment.
Three honest tests before you sign
- The repayment plan test. Can you name, with amounts and dates, how the principal gets repaid? Savings, investments, a maturing asset, a planned sale with a price that covers costs — if the answer is vague, the loan is not ready to sign.
- The rate-rise test. Can you afford the payment if the rate rises two points on the full balance? On $400,000, 6% to 8% means $2,000 to $2,667. If that breaks the budget, the loan is too big for the interest-only structure.
- The exit test. If you could not refinance and could not sell above the balance, what would you do? If there is no good answer, the loan depends on conditions you do not control.
Pass all three and interest-only can be a rational tool. Fail any one and it is a gamble dressed as a payment plan.
Frequently asked questions
What is an interest-only loan payment?
One month’s interest on the full balance: balance × annual rate ÷ 12. On $400,000 at 6%, that is $2,000 a month, and the balance does not fall at all.
Is an interest-only mortgage cheaper than a repayment mortgage?
Monthly, yes; in total, no. On $400,000 at 6% over 30 years, interest-only costs about $720,000 in interest and still owes $400,000, while a repayment mortgage costs about $463,400 in interest and ends at zero.
What happens at the end of an interest-only period?
The full principal becomes due. You must repay it from savings, sell the property for enough to cover the balance plus selling costs, refinance, or convert to a repayment mortgage at a much higher payment.
Can interest-only ever be a good idea?
Yes, for borrowers with irregular income who make real lump-sum principal payments, short-term holders with a firm exit, or investors whose alternative returns reliably beat the mortgage rate after tax — and who pass the repayment-plan, rate-rise, and exit tests.
What if house prices fall during an interest-only loan?
You go underwater immediately, because no principal has been repaid. A 10% fall on a $400,000 home leaves a $360,000 property securing a $400,000 loan, which can block refinancing.
How much does the payment rise if rates go up?
In proportion to the full balance. On $400,000, a rise from 6% to 8% lifts the payment from $2,000 to $2,667 a month — a 33% jump — because the balance never shrank.
Compare interest-only against repayment on your loan
Run your own numbers instead of guessing from someone else’s example.