Updated · Part of the CRE investment glossary
How an interest-only period works
A loan can be interest-only for its whole term, for part of it, or not at all. During the IO period the payment covers interest only, so it is lower than an amortizing payment and the balance stays where it started. When the period ends, payments switch to principal and interest on the amortization schedule the loan sets, and they jump.
Sponsors want IO periods because they raise cash flow while the business plan is under way, before renovations or lease-up lift NOI. Lenders weigh the higher cash flow against two costs: no principal is repaid early, and the borrower must handle the payment increase later or refinance first.
The formula
For a fixed-rate loan with monthly payments:
Interest-only annual debt service = loan × annual rate Amortizing monthly payment = loan × (r ÷ 12) ÷ (1 − (1 + r ÷ 12)^−n) DSCR = NOI ÷ annual debt service
- r: the annual interest rate as a decimal. n: the number of monthly payments in the amortization schedule, e.g. 360 for 30 years.
- If amortization after the IO period runs on the full schedule, the balance at maturity is higher than if the loan had amortized from day one.
Worked example: three years interest-only on a 10-year loan
A property earns $900,000 of NOI. The loan is $10,000,000 at a fixed 6.0% for ten years: interest-only for years 1 to 3, then payments on a 30-year amortization schedule. The rate is an example, not a market figure.
Interest-only debt service is $10,000,000 × 6.0% = $600,000 a year, so DSCR is 1.50x. From year 4 the monthly payment is $59,955.05, or $719,461 a year, 19.9% more, and DSCR falls to 1.25x with no change in the property. The IO period adds $119,461 a year of cash flow in years 1 to 3, and leaves $8,963,939 owed at maturity, against $8,368,572 if the loan had amortized from the first payment.
| Period | Annual debt service | DSCR | Balance at year 10 |
|---|---|---|---|
| Years 1–3, interest-only | $600,000 | 1.50x | — |
| Years 4–10, amortizing | $719,461 | 1.25x | $8,963,939 |
| Amortizing from year 1 (for comparison) | $719,461 | 1.25x | $8,368,572 |
How lenders and underwriters treat it
Lenders often size a loan and test coverage on the amortizing payment even when the loan starts interest-only, so the IO period does not let the borrower take more debt than the property can carry later. Some loan programs grant longer IO periods at lower leverage. Underwriters model both periods and show DSCR and cash-on-cash before and after the switch.
For floating-rate loans the same logic applies to the rate: interest-only payments move with the index, so a rate cap or hedge sets how high the payment can go during the IO period.
What to watch for
Interest-only debt flatters the early years:
- Cash-on-cash and DSCR quoted on IO payments only, without the post-IO figures beside them.
- An IO period that ends before the business plan has raised NOI enough to cover the amortizing payment.
- A balance at maturity that a refinance at a higher rate or lower value may not cover.
- Distributions funded by the IO cash flow that will not continue once amortization starts.
General information, not legal, tax or investment advice. Your operating agreement, offering documents, counsel and CPA govern your deal.