Interest-only mortgage payment:
formula and worked example

What an interest-only mortgage payment means

With an interest-only arrangement you pay just the interest accrued each month and leave the principal untouched for an agreed period. The payment is smaller than a standard instalment because it carries no repayment of the debt itself, which is why it appeals to buyers who expect rising income, plan to sell, or want to keep cash flow light in the early years.

The catch is that the balance on the last interest-only day is the balance on the first. The saving in monthly outgo is borrowed from the future, so the figure is only half the picture until you also know what happens afterwards.

The formula: annual interest divided by twelve

Multiply the outstanding principal by the annual rate to get a year of interest, then divide by twelve for a monthly amount.

• Loan: the outstanding principal, which stays constant during the interest-only period.
• Annual rate: the nominal yearly rate as a decimal, so 7.5% is 0.075.

Some lenders compute interest on the actual days in each month, so the payment moves slightly between months. Dividing by twelve is the standard approximation and will be close enough for planning.

It is worth knowing how the interest-only payment relates to a full instalment. A standard instalment on a loan is the interest component plus a principal component, so an interest-only payment is always the smaller of the two for the same rate and balance. The gap in the early years is the principal you are choosing not to repay, and it is that deferred amount that makes the later instalment larger than it would otherwise have been.

Worked example: 3,200,000 at 7.5%

1. 1Annual interest: 3,200,000 x 0.075 = 240,000.
2. 2Monthly share: 240,000 / 12 = 20,000.
3. 3Principal after twelve payments: still 3,200,000, because nothing was repaid.

Over a ten-year interest-only period you would have paid 2,400,000 in interest and owe exactly what you borrowed. That is the cost of the lower instalment, and it is worth writing down before accepting the product.

What the number does not show: the step-up

Once the interest-only window closes, the loan switches to a repayment schedule. If the full term was twenty years and the interest-only years use up part of it, the same 3,200,000 must be cleared in the years that remain. At the same 7.5% over a fresh twenty years, a standard instalment on this loan would be about 25,800 a month, nearly 29% above the interest-only figure, and shorter remaining terms push it higher still.

Rate changes add another layer. On a floating-rate product, a rise of a point or two in the annual rate increases the interest-only amount directly, because the principal never shrinks to soften the blow. Whether the instalment is acceptable should be tested at the higher payment, not the lower one.

Lenders often attach conditions to interest-only borrowing. They may ask for a larger deposit, a stronger income record or a clear plan for repaying the principal. Those conditions reflect the risk that the borrower cannot clear the balance when the period ends. Having a documented repayment plan, such as the sale of another asset or a growing investment pot, is both what the lender will ask for and what protects you.

For investment property, the interest-only figure is often compared with rent. If rent covers the interest and costs, the property carries itself, but the debt remains and any fall in value is borne fully by the owner.

How the payment responds to the loan amount

Borrowing a tenth more adds a tenth to the monthly cost. Since the principal never falls, a bigger loan also means a bigger step-up later, so the gap between the interest-only and repayment amounts widens along with the loan.

Mistakes that catch borrowers out

• Budgeting only for the interest-only amount and ignoring the larger repayment that begins later.
• Assuming the property will have risen enough to cover the balance, with no plan if prices flatten or fall.
• Forgetting that a floating rate can raise the payment even though the principal is unchanged.
• Mixing up the nominal annual rate with an effective rate or APR that already includes fees.

A further oversight is ignoring the cost of being unable to refinance. If rates or your circumstances worsen, the option to switch to another lender can disappear just when you need it, leaving the step-up on the original terms.

Planning for the end of the interest-only period

Decide in advance how the principal will be cleared. The options are usually a lump sum from a sale or investment, refinancing into a repayment loan, or a switch to a standard schedule on the lender's terms. Each depends on factors you cannot control, so a fallback matters.

1. 1Write down the date the interest-only period ends and the balance then.
2. 2Calculate the repayment instalment on the remaining term at a conservative rate.
3. 3Set aside the difference in a separate account in the meantime if you can.
4. 4Review the plan yearly rather than at the final deadline.