The Cost of a Interest-Only Loan

Because an interest-only loan requires a somewhat smaller monthly payment, more people are able to qualify for an interest-only loan than qualify for a fully-amortized loan. The lower monthly mortgage payment, however, hides the fact that an interest-only loan winds up costing you more in interest over the life of the loan than would a fully-amortized loan.

The reason for this is not difficult to understand. With a fully-amortized loan a portion of your monthly loan payment is used to pay down the principal of your loan. As the principal of your loan is paid down, the interest portion of your payment becomes less each month since there is less principal with each passing month for interest to be assessed on.

So in a traditional fully-amortized loan, the amount of the payment that you make each month that goes toward interest drops slightly each month and the amount that goes to pay off your principal goes up a little each month. That is not the case with an interest-only loan.

With an interest-only loan 100 percent of your payment each month goes to pay interest and none goes to pay-down the principal. Since the amount of your loan payment that goes to pay interest remains constant each month rather than becoming smaller each month as it does with a fully-amortized loan, over time you end up paying considerably more in interest for an interest-only loan than you do for a fully-amortized loan.

And since the principal must be repaid in full with both types of loans, the bottom line is that the interest-only loan is actually a much more expensive loan than the fully-amortized loan.