What Is an Interest-Only Loan?

A lender granting an interest-only period still underwrites the loan against a repayment test, even though no principal is scheduled to amortize during that window. Bridge lenders check whether projected stabilized income, once the business plan is complete, would cover an amortizing payment at a market rate, not just the lighter IO payment in place today. Permanent lenders run a similar shadow test: they calculate the debt service coverage ratio the loan would carry once amortization begins, and they size proceeds so that later payment clears their minimum DSCR, often 1.20x to 1.35x, rather than sizing purely off the IO-period cash flow.

This matters because a property that comfortably covers an interest-only payment can fall short once principal paydown starts. A lender that ignored the post-IO payment would be lending against a number the borrower will never actually pay long term. Sponsors requesting a longer IO period, or a full-term IO bridge loan, should expect the lender to press harder on the exit: how the business plan produces enough stabilized income to support the eventual amortizing payment, or a refinance sized to retire the loan before amortization ever starts.

Bridge loans are commonly interest-only for the entire term because the loan is expected to be repaid through refinance or sale before any amortization would occur. Permanent loans handle IO differently: agency and life-company lenders typically cap the interest-only period at one to five years within a longer 10-year term, after which the loan converts automatically to a 25 to 30-year amortization schedule for the remainder. A sponsor negotiating a permanent loan is really negotiating two numbers, the length of the IO period and the amortization schedule that follows it, not a single interest-only feature.

Lenders typically charge a rate premium for a longer IO period, often 10 to 25 basis points above what the same loan would price at with immediate amortization, because IO extends the point at which the lender's exposure starts shrinking. Some permanent lenders also condition a longer IO period on a minimum DSCR at closing, so a property underwritten at 1.25x might qualify for two years of IO while one at 1.45x qualifies for five.

Because no principal is repaid during an interest-only period, the balance due at maturity or at conversion to amortization is the full original loan amount, unreduced by any paydown. If interest rates have risen, or the property's income has not grown as projected, refinancing that full balance can be harder than it appeared at closing. A sponsor who assumed a 6% refinance rate but faces an 8% market has to support a materially higher payment on the same principal, which can push DSCR below what a takeout lender will accept.

Some lenders address this by requiring an interest rate cap on floating-rate IO loans, which limits how far the rate can rise during the term, or by structuring a partial cash sweep once income exceeds a threshold, directing excess cash flow toward a reserve rather than distributions. Both tools reduce, but do not eliminate, the exposure created by a balance that never shrinks.

The promissory note and loan agreement specify the interest-only period by date rather than by description, along with the exact conversion mechanics: the amortization schedule that takes effect afterward, how the new payment is recalculated, and whether the borrower must request conversion or it happens automatically. Prepayment provisions are tied to this structure too. Many IO loans carry a yield maintenance or step-down prepayment premium calculated against the interest the lender expected to collect, which can make an early payoff during the IO period more expensive than the same payoff on an amortizing loan.

Sponsors should also check whether the loan agreement lets the lender extend or shorten the IO period unilaterally based on a covenant test, such as a DSCR or occupancy trigger, versus fixing the IO period regardless of performance. A loan that ties the IO period to ongoing covenant compliance introduces a variable the sponsor needs to track throughout the hold, not just at closing.

As an illustration, compare a $12,000,000 loan under two rate environments. At 7%, an interest-only payment is $70,000 per month, versus roughly $79,850 per month on a 30-year amortizing schedule at the same rate, a monthly savings of about $9,850. At 9%, the interest-only payment rises to $90,000 per month, versus roughly $96,530 amortizing, narrowing the monthly savings to about $6,530. The dollar savings from choosing IO shrink as rates rise, even though the payment itself is higher in absolute terms, because a larger share of the amortizing payment at higher rates is still interest rather than principal.

Over a 24-month bridge term, this illustration means the sponsor preserves roughly $236,000 in cash flow at 7% by choosing IO, versus about $157,000 at 9%. In both cases, the full $12,000,000 principal remains due at maturity, so the cash preserved during the term needs to be weighed against the size of the balloon payment the refinance or sale must cover.

The interest-only feature has more moving parts than a single yes-or-no election, and each one is negotiable at term sheet stage rather than fixed by convention.