How to Calculate Interest-Only Mortgage Payments

An interest-only mortgage payment is a repayment structure where, for a predetermined period, the borrower pays only the interest that accrues on the outstanding principal balance. During this phase, the actual principal amount of the loan remains unchanged, as no portion of the payment is applied to reduce the original debt. This payment type differs from a traditional amortizing loan where each payment includes both interest and a portion of the principal, gradually reducing the loan balance over time.

Understanding Essential Components

Calculating an interest-only mortgage payment relies on identifying several core elements of the loan agreement. The first component is the principal balance, which refers to the total amount of money borrowed or the remaining unpaid portion of the loan. This figure forms the basis upon which interest is calculated.

Another component is the interest rate, typically quoted as an annual percentage rate (APR). While the rate is expressed annually, mortgage payments are almost universally made on a monthly basis.

The payment frequency is the final component, dictating how often payments are made and, consequently, how often interest is calculated. For mortgages in the United States, payments are almost universally scheduled monthly.

The Interest-Only Payment Formula

The calculation of an interest-only mortgage payment employs a straightforward formula. The standard formula is: Monthly Interest Payment = (Principal Balance × Annual Interest Rate) / 12.

In this formula, “Principal Balance” refers to the current outstanding loan amount. The “Annual Interest Rate” is the yearly percentage rate charged by the lender, which must be used in its decimal form for the calculation; for example, a 5% annual interest rate would be represented as 0.05.

The constant “12” in the denominator accounts for the monthly payment frequency. By dividing the product of the principal balance and the annual interest rate by 12, the formula effectively converts the annual interest cost into a monthly interest cost.

Practical Calculation Examples

Consider a mortgage with a principal balance of $250,000 and an annual interest rate of 4.5%. To calculate the monthly interest-only payment, first convert the annual interest rate from a percentage to a decimal by dividing it by 100, which results in 0.045.

Next, multiply the principal balance by this decimal interest rate: $250,000 multiplied by 0.045 equals $11,250. The final step involves dividing this annual interest amount by 12. Therefore, $11,250 divided by 12 yields a monthly interest-only payment of $937.50.

For another illustration, imagine a loan with a principal balance of $400,000 and an annual interest rate of 6%. Convert the 6% annual interest rate to its decimal form, which is 0.06. Multiply the principal balance by this decimal: $400,000 times 0.06 equals $24,000. To determine the monthly interest payment, divide this annual interest by 12. Thus, $24,000 divided by 12 results in a monthly interest-only payment of $2,000.