Interest-only mortgage

An interest-only (IO) mortgage is a home loan where the borrower pays only the interest accruing on the balance for an initial period — typically 3 to 10 years — without reducing the principal. After the IO period ends, the loan converts to standard principal-and-interest (P&I) repayments over the remaining term.

How it works

During the IO period the monthly payment equals the loan balance multiplied by the monthly interest rate. On a $500,000 loan at 6%, that’s $500,000 × 6% / 12 = $2,500 per month. The balance at the end of the IO period is still $500,000.

When the IO period ends, the full balance must be amortised over the remaining term — not the original term. A 30-year loan with a 5-year IO period leaves only 25 years for full P&I amortisation, which produces a noticeably higher monthly payment.

The payment shock

The jump from the IO payment to the post-IO P&I payment is the single most important consequence of choosing an interest-only structure. Typical shocks are 25–50% above the IO payment, sometimes higher for longer IO periods or lower interest rates. Borrowers who haven’t planned for this transition often face acute cash-flow stress when it arrives.

Total interest premium

Because the principal stays untouched during the IO period, more interest accrues than under an equivalent standard P&I loan. Across a 30-year loan with a 5-year IO period, the typical interest premium is 10–15% above the equivalent full-term P&I — meaning the borrower pays significantly more for the privilege of smaller payments early on.

When IO makes sense

• Investment properties in jurisdictions where loan interest is tax-deductible against rental income, but principal repayments are not — IO maximises deductible expenses.
• Bridging short-term cash-flow constraints where the borrower has a clear plan to move to P&I when the constraint passes.
• Imminent sale or refinance within the IO window, where principal repayments are a wasted effort.

When IO is dangerous

When IO is used to “afford” a larger loan than the borrower could actually service under standard P&I — the smaller initial payment makes the larger property fit the budget today, but the post-IO payment shock is unsustainable. This is the most common pattern of interest-only-related financial distress.

The right way to evaluate an IO loan is to look at both the IO payment and the post-IO payment and ask: can the household afford the post-IO payment today? If not, the IO structure is being used as a borrowing capacity hack, not a structural tool.