Quick answer
An interest-only business loan lets you pay only the interest for an agreed period, so repayments are lower and the balance doesn't fall. When the period ends, repayments usually jump because the full principal must be repaid over a shorter remaining term, or paid out in one go. It suits short-term needs with a clear exit, not open-ended borrowing.
Key points
- During the interest-only period the balance does not reduce, so you owe as much on the last day as on the first
- When principal starts, repayments can jump several times over, because the same debt is spread across a shorter term
- Over the full life, an interest-only period normally costs more than repaying principal from day one
- It fits bridging, construction, development and short projects where a sale or refinance is the exit
- Lenders may assess you on the higher repayment you will face later, not the one you pay now
Picture two repayment lines on a page. One is flat for a year, comfortably low, and then climbs a cliff. The other starts higher and stays level. Both end up clearing the same debt. Interest-only lending is the first line, and the whole skill in using it is knowing where the cliff is.
That doesn’t make it a bad product. For some jobs it is exactly right. For others it hides a problem until the day it arrives.
What does interest-only mean?
Every loan repayment is made of two parts. Interest is the charge for borrowing the money. Principal is the money you borrowed. A standard loan, called principal and interest, pays some of both each time so that the balance falls to zero by the end.
An interest-only loan pays just the first part for a stated period. The balance stays exactly where it started.
| Principal and interest | Interest-only period | |
|---|---|---|
| What each repayment covers | Interest plus a slice of principal | Interest only |
| Balance over time | Falls steadily | Stays flat |
| Repayment size | Higher | Lower |
| Debt left when the period ends | Less than you borrowed | The full amount you borrowed |
The cliff: what happens when principal starts
Here is an illustrative example. A $500k loan runs for five years, with the first 12 months interest-only. The numbers use one assumed pricing level throughout, to show the shape. They aren’t a quote.
| Period | Monthly repayment | What it does |
|---|---|---|
| Months 1 to 12 (interest-only) | $2,500 | Pays interest; balance stays at $500,000 |
| Months 13 to 60 (principal and interest) | $11,743 | Pays interest and clears the full $500,000 over four years |
The repayment goes from $2,500 to $11,743. That’s a rise of $9,243 a month, or nearly five times. Nothing about the pricing changed. The only difference is that principal is now being repaid, over four years instead of five, from a balance that never shrank.
If the owner planned for $2,500 a month and treated the rest as a problem for next year, month 13 brings a shock. If they planned for a sale, a refinance or a contract payment to clear the debt before then, the interest-only year did its job.
This is also why lenders look past the first repayment. Many assess whether you can handle the repayment that follows, not just the one you pay first. Ask your lender which repayment they tested. Our guide to what lenders mean by serviceability covers how that test works.
If you already know your exit and want to see which lenders suit it, you can send a quick enquiry at any point.
Does interest-only cost more?
Almost always, in total. You hold the full balance for longer, so more interest accrues. Using the same example, the owner who repays principal from day one over the five years pays less interest across the term than the owner who spends the first year on interest alone, then repays the rest in four.
The lower repayment is a loan of its own, in effect: you are borrowing cash flow from the future and paying for it. That’s often worth it. The mistake is to treat the saving as free.
If you’d like to see the numbers on your own loan, the business loan repayment calculator shows what a given term and amount does to the repayment, and the true cost guide explains how to add up the whole bill.
When does interest-only make sense?
The pattern is the same each time: the loan is a bridge to something that will repay it.
- Bridging finance. You are buying before you sell, and the sale will clear the loan. See bridging loans explained.
- Construction and development. Money is drawn in stages and the finished project is sold or refinanced.
- Short project funding. A contract will pay in three months and the loan covers the gap.
- A short-term property loan with a clear exit. Secured on property, repaid by refinance.
- Seasonal businesses. The off-season is quiet, so interest-only repayments fit until the busy period.
In each case the exit is the point. The exit strategy glossary entry and the guide on exit strategies for a short-term loan are worth reading before you commit.
When is it the wrong choice?
Be cautious if:
- The reason is simply that you can’t afford a normal repayment. That usually means the loan is too big, and an interest-only period delays the problem rather than solving it.
- The exit is a hope rather than a plan, for example a sale at a price you haven’t tested.
- The asset you’re funding loses value, such as a vehicle or equipment, so the balance stays high while the asset’s worth falls.
- The loan runs for years with no date when principal starts, and you can’t say how it will ever be cleared.
A hire purchase or chattel mortgage that reduces the balance each month may simply be a better fit for equipment.
Where does a bank fit in?
Banks offer interest-only periods too, usually on property-secured and larger commercial facilities, and the terms are often some of the most competitive you will find. If you fit a bank’s criteria and the interest-only period is for a defined purpose, take their offer seriously. The caution above applies equally. Check what repayment they test you on, whether the interest-only period can be renewed, and what happens on the day it ends.
If a bank has said no, the exit-driven lenders in the private and bridging market are built for the bridging situations above, and they price and assess in different ways. Our page on bridging finance explains them.
What else can look like interest-only?
Two similar arrangements are easy to confuse.
- Capitalised interest adds the interest to the balance instead of you paying it, so the debt grows. You make no repayments, but you owe more.
- Prepaid interest takes the interest from the advance at settlement, so you receive less cash but make no interest payments for that period.
All three remove monthly cash outflow in the short run, and each does it differently. Which you want depends on how you’d rather feel the cost: in a smaller advance, a bigger balance, or a regular payment.
A checklist before you sign
- On what date does the interest-only period end, exactly?
- What will the repayment be on the first day after that, in dollars?
- Can the period be extended, and what does it cost?
- What happens if I can’t refinance or sell by then?
- Is there a fee to switch to principal and interest early, or to repay in full?
- Which repayment did the lender use when it assessed me?
Take the answers to your accountant. Interest on borrowing used to earn business income is generally deductible whether or not you repay principal, and your accountant can tell you how that applies to your structure.
Thinking about an interest-only loan?
If this fits something you’re planning, tell us about it. The enquiry is about a minute long, and your credit file stays untouched when you ask. We don’t broadcast your details to a long list of lenders. Someone here reads your situation properly and phones you. The most helpful thing you can do is be exact on the form: the amount, the property or asset, and how you’ll repay. That lets us suggest the right type of lender straight away.
Frequently asked questions
What is an interest-only business loan?
It is a loan where, for a set period, your repayments cover only the interest charged and none of the principal. The amount you owe stays the same. At the end of the period the loan either converts to principal and interest repayments or the whole balance falls due.
How long can the interest-only period last?
It varies by lender and product. Short-term bridging and caveat loans may be interest-only for their whole term of a few months to a year or two. Longer term loans often offer an interest-only period of one to five years before repayments change. Check the contract for the exact dates.
Why do repayments jump after the interest-only period?
Because you now repay the same principal over fewer remaining years. A loan with five years in total and one year interest-only has four years left to clear everything, so each repayment must carry far more principal than it would have over the full five.
Is an interest-only loan cheaper?
The monthly repayment is lower, but the total cost is usually higher than a loan that reduces from day one, because you carry the full balance for longer. It is cheaper only in the cash-flow sense, and it is a poor choice if the lower repayment tempts you to borrow more than you need.
Is the interest on an interest-only loan tax deductible?
Interest on money borrowed for business purposes is generally deductible whether you repay principal or not, as long as the borrowing is used to produce assessable income. The treatment depends on your structure and how funds are used, so confirm it with your accountant.
What is the exit strategy for an interest-only loan?
It is how you will repay the principal: a sale of a property or asset, a refinance onto a term loan, an incoming settlement, or ongoing repayments once principal begins. Lenders often ask about it up front, and you should be able to explain it clearly.