Interest only or amortizing: which is better on a commercial loan?
Interest only lowers the payment while it lasts and raises what the loan costs in total. Nothing is repaid during it, so the balance stays where it started, every month of interest afterwards is charged on that larger balance, and more falls due at maturity. It is worth taking when the business plan genuinely needs the cash in those specific years and you have a credible answer for the bigger balloon. It is expensive when it is taken to make a deal pencil that otherwise would not.
What the two structures actually differ on
During an interest only period you pay the coupon on the outstanding balance and nothing else, so the balance does not move. On an amortizing loan each payment covers the interest first and reduces the principal with what is left, so the balance falls a little every month and the interest charged the following month falls with it.
The payment on the amortizing loan is computed on the full amortization schedule, and an interest only period does not shorten that schedule. Two years of interest only in front of thirty year amortization means the payment, when it starts, is still the thirty year payment, and the loan still has thirty years of schedule left to run against a term that has already used two of its years.
The trade, in figures
Take a 6,300,000 dollar loan at 6.5 percent, thirty year amortization, ten year term, and compare it with and without two years of interest only at the front. The figures are illustrative arithmetic on a made up quote, and both columns are the same loan.
- Two years of lighter payments cost about 107,788 dollars of extra interest across the term
- They also leave about 244,475 dollars more outstanding on the maturity date, which has to be refinanced or repaid
- The payment steps up by about 5,695 dollars in month 25 and never comes back down
| Over the ten year term | With 24 months IO | Amortizing from day one |
|---|---|---|
| Monthly payment in year one | 34,125 | 39,820 |
| Monthly payment from year three | 39,820 | 39,820 |
| Interest paid over the term | 3,927,118 | 3,819,330 |
| Balance owed at maturity | 5,585,370 | 5,340,895 |
What it does to the coverage ratio
This is the part that catches people, because the optics run backwards. While the loan is interest only the payment is smaller, so the debt service coverage ratio is higher. On the loan above, 600,000 dollars of NOI covers the interest only payment at about 1.47x and the amortizing payment at about 1.26x. Same property, same income, same loan, two ratios more than two tenths apart.
A lender sizes the loan against the amortizing payment for exactly this reason: that is the payment the property has to carry for most of the term. A borrower who quotes the interest only ratio is quoting the years in which nothing is being repaid. A deal can look comfortable in year one and tight in year three with nothing at the property having changed, so coverage should be run for every year of the hold and reported at its minimum rather than at its first.
When interest only earns its cost
It is not a trick and it is often the right structure. What it buys is cash in specific years, and there are real plans that need it.
- A lease up, where the income is not there yet and will be. Paying principal out of a shortfall is worse than paying interest
- A renovation program, where the cash is better spent on the units that produce the premium than on retiring debt at the coupon
- A property with heavy near term rollover, where the tenant improvement and leasing commission bill lands before the new rent does
- A short hold, where the principal you would have repaid comes straight back to you at the sale anyway and the timing of the cash matters more than the balance
What it costs beyond the interest
The larger balloon is the real exposure and it is the one to underwrite. A loan that ends its term with a higher balance needs a bigger refinance in a rate environment nobody can promise you, and refinancing risk is a function of the balance, the income at that point and the debt yield a lender will apply to it. Interest only raises the first of those three and does nothing for the other two.
It also changes what the return is made of. Early cash flow rises, so the year one cash on cash and the IRR both improve, while the equity built through principal repayment falls, so the proceeds at sale are lower. On a short hold those roughly offset. On a long hold, or a deal where the exit is uncertain, they do not, and the version of the deal that looked better in year one can end up returning less.
How to decide
Run both. Not the payment on both, the whole model on both: the coverage in every year, the balance at maturity, the refinance at a rate you are not confident about, and the return in the base case and the downside. The comparison takes minutes in a model that recomputes, and the answer is frequently not the one the first year payment suggests. Altyst carries the debt structure through every year of the hold, so switching the interest only period and re reading the coverage, the balloon and the return is one edit rather than a rebuild.
Related questions
Does an interest only period make a loan cheaper?
No. It makes the early payments smaller and the loan more expensive overall. Nothing is repaid while it runs, so the balance stays at its opening figure, every month of interest after that is charged on a larger balance, and more is owed at maturity. What it buys is cash flow in the years the plan needs it, which can be worth the cost, but it is a trade rather than a saving.
Why does my payment jump when interest only ends?
Because the amortizing payment was deferred rather than reduced. When the interest only period ends you begin paying the full level payment computed on the entire amortization schedule, which still has its original length. The step is the difference between the coupon on the balance and that full payment, and on a typical quote it is a meaningful double digit percentage increase that arrives in a single month.
Is full term interest only available on commercial loans?
It exists, most often on lower leverage loans, on strongly covenanted single tenant assets, and in parts of the securitized market where it moves in and out of fashion with the credit cycle. It concentrates the entire principal at maturity, so it is priced and sized accordingly, and the refinancing question becomes the whole question. Whether it is on offer for a given deal is a term sheet matter rather than a rule.
Does interest only affect how much I can borrow?
Usually not, because most lenders size the loan against the amortizing payment even when the loan starts interest only. That is deliberate: sizing to the interest only payment would let a loan qualify at proceeds the property cannot service in the month amortization begins. The structure changes what you pay in the early years, not what the coverage test will allow.
Should I take interest only on a five year hold?
It is a real question rather than a rule, and the answer turns on what you would do with the cash. Principal repaid on a short hold comes back at the sale, so deferring it mainly shifts timing rather than destroying value, and if the cash funds a renovation that raises the exit value the trade can be clearly positive. If it simply makes a thin deal look serviceable, the extra interest and the larger balloon are being paid for a presentation.
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