When searching around for various types of loans and interest only loan can sound like a real good idea.  While this type of loan initial is very enticing they can actually get people into a lot of trouble if you do not stop and consider all of the numbers and make sure that you can pay back the entire loan in the specified time.  Because many people will only look at the interest only payments portions of the loan they will not realize that the actual payments they will have to make down the road will increase substantially.

In order to calculate interest only loans there are a few steps we need to take.  The first step is to figure out the exact amount of interest we will have to pay on our loan.  Lets say you take out an interest only loan for $400,000 at an interest rate of 5%.  The usual length of an interest only loan is 30 years so that means that every year you must pay 5% on that initial $400,000 in interest. 

This amounts to $600,000 in interest that will also need to be repaid.  To figure out the monthly payments for the interest only portion of our loan we will take that $600,000 of total interest and divide it by the number of months in the term of the loan.  With 12 months in a year and 30 years in our loan terms we arrive at 360 months.  $600,000 divided by 360 equals $1,666.67.  This amount is our monthly payment that must be made during the interest only period.

The next step in calculating an interest only loan is to determine our amortized payments.  This monthly payment will be the amount necessary to pay back the principal of our loan in the initial terms of the loan.  To do this we will divide the principal amount by the remaining number of months after the interest only period has expired. 

Generally the interest only period lasts for 15 years out of the 30 year loan time frame.  So again with 12 months in a year and 15 years left to repay the balance of the loan we come up with 180 months.  $400,000 divided by 180 equals $2,222.22.  This is the monthly amount we will need to pay in order to pay off the principal of our loan in the 30 year time frame.

The last step to calculating an interest only loan is the most important.  Once the interest only period ends you will have to remember that you will start paying the amortized monthly payments in addition to your monthly interest payments.  In our example the monthly payments for the first 15 years, which is the interest only period, are $1,666.67.  Starting in year 16 and continuing until the loan is repaid we will have to add the amortized amount to our monthly interest payments creating a new monthly payment of $3,888.89 ($1,666.67 + $2,222.22). 

It is usually at this point that many people get into trouble with interest only loans as they do not have the funds to pay off the interest and principal loan amount at the same time.  If you are currently thinking of obtaining an interest only loan it is important that you keep this mind and factor it in when deciding whether or not you can afford the monthly payments for this type of loan.

Moe Bedard
My name is Maurice "Moe" Bedard. I am the founder of America's #1 Mortgage Forum, LoanSafe.org. My online work has been featured in the New York Times, LA Times, Fox Business, and many other media publications.