Interest-only period
Also called IO period, Interest only.
An interest-only period is a stretch at the start of a loan during which the borrower pays interest and no principal. It raises early cash flow and coverage, and it ends with a step up in debt service that has to be modelled.
How it works
Interest only is valuable for a real reason on transitional deals. A property in the middle of a renovation programme is producing less income than it will at stabilisation, and deferring amortisation matches the debt service to the income curve rather than fighting it. On a five-year loan with three years of interest only, the first three years of coverage look materially better than the last two.
The cost is concentrated at the end. Because no principal is repaid during the interest-only period, the loan balance at maturity is higher than it would otherwise be, which means a larger balance to refinance or repay at sale, in an interest rate environment nobody can forecast. Full-term interest only takes this to its conclusion: the entire original balance is still outstanding at maturity.
How big the step is depends on a detail worth reading for rather than assuming. Some loans reset onto a fresh thirty-year schedule when the interest-only period ends; others amortise over only the years left in the original schedule, which on a thirty-year schedule after three years of interest only means twenty-seven, and a shorter schedule means a larger payment. On the loan below the difference between those two conventions is about $104,000 a year.
Worked example
$36,335,000 at a 6.35 percent constant, three years interest only, then a fresh thirty-year amortisation schedule. NOI $3,020,000 held flat to isolate the effect.
| Annual debt service, years one to three | $2,307,272 |
|---|---|
| DSCR during interest only | 1.31x |
| Annual debt service from year four | $2,713,072 |
| Increase in annual debt serviceup 17.6% | $405,800 |
| Debt service on a twenty-seven year schedule insteadDSCR 1.07x | $2,816,734 |
| DSCR from year four | 1.11x |
The property did not change and coverage fell by 0.20x, through a 1.20x covenant. In practice NOI would be growing, but the size of the step is the point: it has to be outrun.
The common mistake
Reporting the interest-only DSCR as the deal's coverage
A summary that quotes 1.31x coverage on a loan that amortises from year four is quoting a number that is true for three years of a ten-year loan. If the business plan depends on selling or refinancing before the step, that is a legitimate plan, but it is a plan with an execution risk that should be stated rather than hidden inside a favourable ratio. Model debt service year by year, report the minimum DSCR across the hold, and test what happens if the exit slips two years.
Related terms
- Debt service coverage ratioThe debt service coverage ratio is net operating income divided by annual debt service. A 1.25x means the property produces $1.25 of income for every $1.00 of principal and interest owed, so net operating income could fall by 20 percent before coverage reaches 1.00x and the loan stops being covered.
- Loan constantThe loan constant is annual debt service divided by the original loan balance, expressed as a percentage. It combines the interest rate and the amortisation schedule into one number, which is what makes it the right rate to compare against a cap rate.
- Break-even occupancyBreak-even occupancy is the occupancy level at which a property's collections exactly cover its operating expenses and debt service, with nothing left over. Below it, the property consumes cash instead of producing it.
- Loan sizingLoan sizing is the process of determining the maximum loan proceeds a property supports. A lender runs three independent tests, a loan-to-value cap, a minimum debt service coverage ratio at a stressed rate, and a minimum debt yield, and lends the lowest of the three.
- Yield maintenance and defeasanceYield maintenance and defeasance are the two standard mechanisms that make a fixed-rate commercial mortgage expensive to repay early. Yield maintenance charges the lender's lost interest as a lump sum; defeasance substitutes a portfolio of government securities for the property as collateral.
- Loan to costLoan to cost is the loan amount divided by total project cost. It is the leverage constraint used on construction and heavy value-add loans, where the property has no stabilised value to lend against and cost is the only verifiable basis.
Every figure, traced to its source
Altyst computes these in exact decimal arithmetic, not with a language model, and clicking any number shows the formula behind it.