What it is
On an interest-only loan, the borrower's payments cover interest and nothing else. The loan balance stays the same. An IO period can run for the full term, which is common on bridge loans and construction loans, or for the first part of a permanent loan before amortization begins.
How it changes the numbers
Interest-only payments are smaller than amortizing ones, so cash flow and DSCR look better.
| Interest-only | 30-year amortizing | |
|---|---|---|
| Loan amount | $10,000,000 | $10,000,000 |
| Rate | 6.00% | 6.00% |
| Annual debt service | $600,000 | $719,460 |
| NOI | $900,000 | $900,000 |
| DSCR | 1.50x | 1.25x |
The figures are illustrative. Same loan, same property, a quarter-turn difference in coverage.
Full IO versus partial IO
- Full-term IO. Common on short-term, transitional loans. The whole balance is due at maturity.
- Partial IO. Common on permanent loans. For example, the first two or three years are interest-only, then payments step up to amortize over the remaining schedule.
How lenders underwrite it
Lenders know the IO payment is temporary or that the full balance comes due at the end. Many test DSCR on an amortizing payment even when the loan is interest-only, to make sure the property can handle the step-up. IO is often offered only on lower-leverage deals or stronger properties. It's a feature the deal earns.
Why borrowers want it
- Cash flow. Lower payments early on, when a value-add plan hasn't lifted income yet.
- Return on equity. Less cash going to principal means more available for distributions or capital work.
- Short holds. If the sponsor expects to sell or refinance soon, paying down principal matters less.
The trade-off
No principal reduction means no built-in deleveraging. At maturity or refinance, the full balance has to be covered. If values or income fall, there's less cushion than there would be on an amortizing loan.
Common mistakes
- Quoting IO coverage only. The lender will run the amortizing number too.
- Forgetting the step-up. On partial IO, model the payment jump in the year it happens.
- Using IO to make a weak deal work. If coverage only works interest-only, the refinance may not.
In the package
Show DSCR on both the interest-only and amortizing payments. Try both in the DSCR calculator.