What is an interest-only loan?

An interest-only loan is characterized by the borrower making payments that cover only the interest for a specified period, without paying down the principal. This arrangement allows for lower initial payments during the interest-only phase, which can be appealing to borrowers who expect their financial situation to improve in the future or who plan to sell or refinance before the principal payments begin.

Once the interest-only period ends, the loan typically transitions to a standard amortization schedule where the borrower starts paying off the principal along with interest, which can lead to significantly higher payments at that time. Interest-only loans can be particularly useful in certain financial strategies, but they may also entail risks, such as the potential for negative equity if property values decline.

Other options do not accurately describe an interest-only loan: regular payments of principal and interest involve both components right from the outset, a loan not secured by property is known as an unsecured loan, and being paid off at a higher rate than the market average does not pertain to the structure of an interest-only loan.