Glossary
Interest-Only Loan (IO Period)
An interest-only (IO) loan, or interest-only period, is a loan or portion of a loan term during which the borrower pays only interest and no principal. Payments are lower than on an amortizing loan, but the balance does not decline, so the full principal remains outstanding when the IO period ends.
Formula
Example
A $5,000,000 loan at 6% has an interest-only payment of $300,000 per year ($25,000 per month). On a 30-year amortization, the payment would be about $359,730 per year. With NOI of $450,000, DSCR is 1.50x during the IO period but about 1.25x once amortization begins. Underwriting only to the 1.50x figure would overstate the loan's long-term coverage.
How it is used in underwriting
Interest-only periods are common in commercial real estate, particularly on stabilized properties with low leverage, value-add loans where income is expected to rise, and bridge or construction loans. Borrowers use IO to improve cash flow and returns during lease-up or renovation. Lenders grant it when leverage is moderate and the collateral is strong, but they underwrite the amortizing payment that follows, so the loan must still meet DSCR requirements after the IO period ends. Full-term IO loans are generally limited to lower leverage deals because no principal is repaid before maturity.
The main risk of IO is the payment jump at the end of the period, sometimes called payment shock, combined with a higher balance at maturity. Underwriters model both: coverage after the IO period and the ability to refinance the full balance. Equity investors should note that IO boosts cash-on-cash returns and IRR in early years, which can make a deal look stronger than its underlying economics. In business lending, IO periods are less common but may appear in acquisition loans while a company completes a transition, or in mezzanine debt where interest may be partly paid in kind.
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Frequently asked questions
Why would a borrower choose an interest-only loan?
Interest-only payments improve near-term cash flow, which helps during renovations, lease-up or business transitions, and increases early cash-on-cash returns. Borrowers who plan to sell or refinance before amortization would meaningfully reduce the balance may also prefer IO to keep more capital available for other uses.
How do lenders underwrite interest-only loans?
Most lenders size and test the loan on the amortizing payment that follows the IO period, not just the interest-only payment. They also check leverage and refinance risk at maturity, since no principal is repaid during the IO period. Full-term IO is usually reserved for lower leverage loans on strong properties.
What happens when the interest-only period ends?
When the IO period ends, payments switch to principal and interest based on the remaining amortization schedule, which raises the required payment. If property income has not grown enough, DSCR falls. Borrowers should plan for the higher payment well in advance or arrange to refinance or sell before the change.
Related terms
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