Interest-Only Mortgages: What You Are Deferring

The balance does not move, and that is the whole product

An interest-only payment is not a small repayment. It is a payment with the repayment removed. Each month the lender charges interest on the outstanding balance, you hand over exactly that amount, and the balance is the same in the morning as it was the night before. On $300,000 at 6.00 percent nominal, the monthly rate is 0.06 ÷ 12 = 0.005 and the payment is $300,000 × 0.005 = $1,500.00, flat, for as long as the interest-only period lasts. There is no schedule to look at, because nothing changes.

The comparison that matters is against the same loan repaid. The annuity formula — derived in full in our article on the instalment formula, and applied here rather than rebuilt — returns $1,798.65 a month for $300,000 at 6.00 percent over 360 months. So the interest-only payment saves $298.65 a month, which over ten years is $35,838.19 of cash you did not hand over. That is the benefit, stated at its full value. Everything else in this article is the price of it.

Notice what the saving is not. It is not a discount, and it is not the lender being generous. It is a loan of $298.65 a month from your future self, made at 6 percent, with the whole balance still standing at the end. If that sounds like a description of a debt, it is because it is one — and it is the same debt, unreduced, waiting.

The payment shock, computed rather than feared

This is the number the article exists to produce. At the end of a ten-year interest-only period on a thirty-year loan, the debt is untouched at $300,000, and it must now be repaid over the 240 months that are left. Feed that into the same annuity formula — $300,000, monthly rate 0.005, 240 payments — and it returns $2,149.29. Against the $1,500.00 you were paying the month before, that is a jump of $649.29, or 43.3 percent, arriving in a single billing cycle.

The second comparison is the one people miss and it is more damning. The new payment is not merely higher than the interest-only payment; it is $350.64 higher than the $1,798.65 you would have been paying all along on a plain repayment loan — 19.5 percent above it. In other words, the interest-only borrower does not simply catch up. They spend twenty years paying more than the payment they originally declined, in exchange for having paid less for ten. That asymmetry is arithmetic: the same principal amortised over a shorter term.

The shock scales with the length of the deferral, and not gently. Halve the interest-only period to five years and the remaining term is twenty-five, so the payment becomes $1,932.90 — a jump of $432.90, or 28.9 percent, which is survivable for many households. Stretch it to ten years and you get the 43.3 percent above. Stretch it to the whole term and the loan becomes a bullet: nothing is repaid until the final day, when the entire $300,000 falls due at once and must be found from a sale, a maturing investment, or a new loan. There is a rule of thumb hiding here worth carrying: the shock is driven by how much of the term you have spent, because the shorter the tail, the steeper the climb.

What the deferral costs over the full term

Add the two phases. One hundred and twenty payments of $1,500.00 is $180,000.00, and two hundred and forty of $2,149.29 is $515,830.36, so the interest-only route hands over $695,830.36 in total. The repayment loan hands over 360 × $1,798.65 = $647,514.57. The difference, $48,315.79, is the price of the deferral, and since both loans repay the same $300,000 of principal it is all interest: $395,830.36 against $347,514.57.

There is a tidy coincidence in this particular loan that makes the trade easy to remember, though it is only a coincidence and not a rule: the extra interest, $48,315.79, is almost exactly the principal the repayment borrower had already knocked off by the end of year ten, $48,942.83. Change the rate or the term and the two numbers separate immediately. What does generalise is the direction: keeping a balance high for longer means paying interest on a bigger number for longer, and there is no arrangement of the schedule that avoids it.

One honest caveat on that $48,315.79, and readers of our article on mortgage points will recognise it: those are undiscounted currency units, added across thirty years as if a payment in year twenty-nine weighed the same as one in year one. It does not. If the $298.65 saved each month in the early years is genuinely put to work at a positive return, part of the gap closes. That is exactly the argument a disciplined investor makes for the product, and it is a legitimate argument — but it is a claim about what you will do with the money, not about the loan, and it is the claim that most often turns out to be false.

No equity accrues, and the negative-equity case is the reason to care

Equity is the value of the house minus what you owe on it. A repayment borrower gets equity from two sources: the principal in every instalment, and whatever the market does. An interest-only borrower has only the second. On the loan above, the repayment borrower has built $48,942.83 of equity by the end of year ten from payments alone, whatever prices did. For the interest-only borrower to have matched that, the house has to have risen 13.1 percent over the decade — on a $375,000 purchase, $48,942.83 is 13.05 percent of the price. If it rose less, they are behind. If it fell, the whole fall is theirs.

Work the fall. Take the same $375,000 house bought with 20 percent down and the $300,000 loan, and suppose prices drop 25 percent — a fall that several European markets and the United States all recorded within living memory. The house is worth $281,250. The interest-only borrower still owes $300,000 and is in negative equity by $18,750: selling does not clear the debt, and remortgaging is difficult because there is no equity to lend against. The repayment borrower, five years in, owes $279,163.07 and is still marginally above water at $2,086.93. Same house, same fall, same deposit — opposite side of zero.

This is why the failure mode is specific rather than general. Interest-only does not merely cost more; it removes the buffer that would have absorbed a fall. And the borrower most attracted to the lower payment is, almost by construction, the borrower with the least deposit and the least slack — so the product concentrates itself where it does the most damage. If the plan for repaying the principal is that the house will be worth more, that is not a repayment strategy. It is a position in the housing market, taken with borrowed money, with your home as the collateral.

The uses that are legitimate, and the one that is not

Three cases stand up. The first is genuinely irregular income: a contractor, a commission-paid salesperson or a seasonal business whose annual total is adequate but whose monthly floor is not. A low compulsory payment with voluntary lump-sum reductions when the money arrives can match the loan to the cash flow — provided the lump sums are actually made, and provided the contract permits them without penalty, which is a clause to check rather than assume.

The second is a bridging position: you have bought before selling, and the interest-only loan carries the new property for the months until the old one completes. Here the repayment strategy is not a hope, it is a signed contract on another asset, and the period is measured in months rather than decades. The third is the landlord case, where the calculation is genuinely different: interest on a loan secured against a let property is a cost of the business, the rent services it, and the capital is expected to be settled by an eventual sale. Whether that interest is deductible against rental income is a separate question with a market-specific answer — the United Kingdom, for instance, replaced full deduction for individual landlords with a restricted basic-rate credit — so check your own tax regime rather than assuming the deduction exists.

The illegitimate use is the common one: buying a more expensive house than a repayment loan would have allowed, on the strength of the lower payment, with the deferral itself as the plan. It fails in three directions at once. It maximises interest. It builds no cushion against a fall. And it stakes the outcome on a price rise nobody has promised, at exactly the moment the buyer is least able to absorb the alternative. If the reason you are looking at interest-only is that the repayment payment is out of reach, then the answer the arithmetic gives you is that the house is out of reach — and it will be more out of reach in ten years, when the payment becomes 19.5 percent larger than the one you could not afford today.

Seven markets, seven different products

Interest-only is not one product with one regulatory status. In the United Kingdom it is the mainstream instrument for buy-to-let: the landlord's interest is a business cost, the rent covers it, and the capital is expected to come from an eventual sale. Residential interest-only, by contrast, is tightly constrained — the Financial Conduct Authority's mortgage conduct rules require the lender to obtain evidence of a credible strategy for repaying the capital, and the Bank of England publishes the outstanding interest-only stock precisely because the legacy of loans sold before that requirement is a supervisory concern.

In the United States the constraint runs through the ability-to-repay framework: under the Consumer Financial Protection Bureau's rules a loan with interest-only payments cannot be a Qualified Mortgage, which does not make it illegal but pushes it out of the standard, protected channel and into portfolio lending. The Netherlands offers the sharpest example of policy reversing a market: the interest-only mortgage was once the dominant Dutch product, and the tax treatment of new loans was changed in 2013 to require repayment on at least an annuity basis for the interest deduction to apply. The stock of legacy interest-only loans there remains a live supervisory topic.

In continental Europe the general pattern is a regulated exception rather than a mainstream option, and the local vocabulary is worth knowing because it tells you the shape of the product. France has the prêt in fine, essentially an investor instrument usually paired with a pledged savings contract that is meant to redeem the capital at maturity; residential lending is additionally framed by the Haut Conseil de stabilité financière, which sets binding conditions on debt-service ratios and maximum maturities that have been amended more than once, so read the current decision rather than a summary. Germany has the endfälliges Darlehen, generally requiring an assigned repayment vehicle, against the annuity loan with a contractually stated initial repayment rate that dominates owner-occupier lending.

In Spain, Portugal and Italy the usual form is a short grace period rather than a whole-term product: the carencia de capital in Spain, the carência de capital in Portugal, the preammortamento in Italy. In each case the borrower pays interest only for an initial stretch — often a year or a few years, and sometimes offered as a hardship measure on an existing loan rather than at origination — after which the loan amortises over the shortened remaining term, which is exactly the shock this article computes. The permitted lengths, the conditions and the consumer-protection rules around them are national and they change; the Banco de Portugal client portal and the Banca d'Italia mortgage guide are the kind of primary source to read before signing, and the equivalent supervisory guidance exists in each market. Do not carry a rule across a border.

Frequently asked questions

How much does the payment rise when the interest-only period ends?

On the worked case — $300,000 at 6.00 percent, ten interest-only years inside a thirty-year term — it goes from $1,500.00 to $2,149.29, a rise of $649.29 or 43.3 percent, in one billing cycle. The size of the jump depends on how much of the term you have used, because the untouched balance must amortise over whatever is left. Five interest-only years instead of ten leaves twenty-five to repay and gives $1,932.90, a 28.9 percent rise. Compute your own with the loan amount, the rate and the number of months that will actually remain — not with a percentage rule.

Do I build any equity during an interest-only period?

Only through price movement. Your deposit is your equity on day one and it stays exactly that unless the market moves, because the balance does not fall. On the worked loan, the repayment borrower had built $48,942.83 out of instalments alone by the end of year ten; for the interest-only borrower to match it, the $375,000 house would have had to rise 13.1 percent. If prices fell 25 percent instead, the interest-only borrower is $18,750 in negative equity while the repayment borrower at year five is still just above water. That asymmetry, not the interest, is the real risk of the product.

Is an interest-only mortgage ever the right choice?

Yes, in three situations, and they share one feature: the repayment plan exists independently of house prices. Genuinely irregular income, where a low compulsory payment plus voluntary lump sums matches the loan to the cash flow. A bridging position, where a signed sale on another property will clear the capital within months. And a landlord holding a let property as a business, where interest is a cost the rent services and the capital is settled on eventual sale. The case that is not legitimate is buying more house than a repayment loan allows and expecting appreciation to solve it — that is a leveraged market position, not a financing choice.

Can I make voluntary repayments during the interest-only years?

Often, but never assume it — this is a contract clause, not a market convention, and early-repayment terms differ sharply by country and by lender. Where voluntary reductions are permitted without penalty, they are powerful: every unit repaid cuts the balance, cuts the interest that follows and, crucially, cuts the payment that amortisation will demand later, because that payment is computed on whatever balance survives. Where they attract a compensation charge, the charge may be capped by national consumer-credit law, so check the maximum that applies to you rather than accepting the first figure quoted. Read the clause before signing, not when you first have money to spare.

Why is interest-only normal for landlords but restricted for homes?

Because the two borrowers hold different things. A landlord holds an income-producing asset: the interest is a cost of running it, the rent services that cost, and the capital is expected to be settled by selling the asset, which is a plan that exists on paper before the loan is signed. An owner-occupier holds a home, whose only cash flow is the money going out. Regulators have responded to that difference — the Financial Conduct Authority requires evidence of a credible repayment strategy on residential interest-only lending in the United Kingdom, and the Consumer Financial Protection Bureau's ability-to-repay framework excludes interest-only loans from the Qualified Mortgage definition in the United States. Both are constraints on the residential product, not on the investment one.

What happens if I cannot afford the payment when amortisation starts?

The options at that point are all worse than the options you had at the start, which is why the date belongs in your plan from day one. You can extend the term, which lowers the payment and raises the total interest again; you can refinance, which depends on your income and your equity at the time and on both being acceptable to a lender who is not obliged to help; or you can sell, which depends on the market. If the property has fallen in value, refinancing and selling may both be blocked at once, since there is no equity to lend against and a sale may not clear the balance. The practical defence is to build the post-deferral payment into your budget years before it arrives, and to treat any inability to do so as the answer to whether the loan was affordable.