How to Calculate an Interest Only Payment

An interest-only payment represents a specific loan repayment structure where the borrower pays only the interest that has accrued on the principal balance for a set period. During this initial phase, the principal amount of the loan remains unchanged. This payment type offers borrowers lower initial monthly obligations compared to a fully amortizing loan.

Key Information for Calculation

Calculating an interest-only payment requires specific pieces of information about the loan. The principal balance represents the initial amount of money borrowed or the outstanding amount still owed on the loan. This figure forms the base upon which interest accrues.

The annual interest rate is the stated percentage charged by the lender over a full year, often expressed as an Annual Percentage Rate (APR). It is a key component for determining the periodic interest charge.

Payment frequency indicates how often payments are made within a year. Common frequencies include monthly, quarterly, or annually, and this directly impacts how the annual interest rate is converted for the calculation.

Applying the Interest Only Formula

The calculation of an interest-only payment follows a two-step process. The first step involves converting the annual interest rate into a periodic interest rate that aligns with the payment frequency. To achieve this, the annual interest rate, expressed as a decimal, is divided by the number of payment periods in a year. For instance, if payments are made monthly, the annual rate is divided by 12.

The second step requires multiplying the loan’s principal balance by this newly calculated periodic interest rate. This yields the interest-only payment amount for that specific period. This method ensures that the payment precisely covers the interest accrued on the outstanding principal for the given payment interval. The calculation does not account for any reduction in the principal balance, as is characteristic of an interest-only payment structure.

Illustrative Examples

Consider a loan with a principal balance of $200,000 and an annual interest rate of 6%. If payments are made monthly, the first step is to convert the annual rate to a monthly rate. This is done by dividing 0.06 by 12, resulting in a periodic rate of 0.005. Multiplying the principal balance of $200,000 by this monthly rate of 0.005 yields an interest-only payment of $1,000.

For another scenario, imagine a loan with a principal balance of $500,000 and an annual interest rate of 4.5%. If payments are structured quarterly, the annual rate must be converted to a quarterly rate. Dividing 0.045 by 4 results in a periodic rate of 0.01125. When this quarterly rate is multiplied by the $500,000 principal balance, the interest-only payment amounts to $5,625 for each quarter. These examples demonstrate the application of the formula across loan amounts and payment frequencies.