An interest-only loan is simply a loan where the borrower is obligated to pay only the interest on the loan for a certain period of time, whether that be for a portion of the loan period or the entire loan period (with the obligation to pay back the principal of the loan at the end of loan period).
How to Calculate Payments
For the interest-only period, payments each period will be the interest rate per period multiplied by the full value of the loan.
For the remainder of the loan period, calculating the full payments after the interest-only period is no different than it is with any ordinary loan. The formula to calculate the full loan payments is nothing more than a rearranged version of the ordinary annuity formula. The rearranged formula is shown below:
- PMT = total payment each period
- PV = present value of loan (loan amount)
- i = period interest rate expressed as a decimal
- n = number of loan payments
Suppose you take out a $100,000 loan from the bank. The bank you are working with has offered you a fixed interest rate of 5.0% over a five-year period, with the first year being an optional interest-only period. You choose to accept the interest-only period option, and you also choose to make monthly payments.
We can intuitively think of this as a year of paying interest with no principal repayment required and then a four-year loan with principal payment required. The interest rate per period will be 0.05/12 since the payments are made monthly.
For the first year, you simply pay each month this monthly interest rate multiplied by the total value of the loan. The payments for the first twelve months will be calculated as follows:
So, for the first twelve months, you will pay $416.67. Now, we must look at how to calculate payments each month during the next four years.
We will use the ordinary annuity formula to calculate each monthly payment for the next four years. The present value here is $100,000, which is the value of the loan. The monthly interest rate will be the same as above, 0.05/12. The number of mortgage payments is 48, which is twelve payments per year for four years. The work to calculate the next 48 months’ payments is shown below:
So, for months 1-12, you will pay $416.67, and for months 13-60, you will pay $2,302.93.