Interest-Only Period
Also called: IO period, Interest only
An interest-only period is a stretch at the start of a loan term during which the borrower pays only accrued interest and no principal, lowering debt service and raising early cash flow.
Interest-only is one of the highest leverage terms in a loan negotiation because it directly increases early distributions and therefore IRR, without changing the purchase price. Two otherwise identical loans, one with three years of interest-only and one with none, can differ by more than a full point of IRR on a five year hold.
The tradeoff is that no principal is amortized during the period, so the loan balance at exit is higher and net sale proceeds are lower. Interest-only improves the timing of cash flow rather than the total amount of it, which is precisely the distortion the equity multiple is useful for catching.
Rules of thumb
- Model the amortization step-down explicitly. Cash-on-cash will fall in the year interest-only burns off, and a plan that only pencils during the interest-only window is fragile.
- Full-term interest-only maximizes IRR but leaves the entire principal outstanding at maturity, concentrating refinance risk at exit.
Calculate interest-only period
Related terms
- Cash-on-Cash Return
Cash-on-cash return is the annual pre-tax cash flow after debt service divided by the total equity invested, measuring the yearly cash yield an investor actually receives on their money.
- Debt Service Coverage Ratio (DSCR)
The debt service coverage ratio is net operating income divided by total annual debt service, and it measures how many times a property's income covers its loan payments.
- Internal Rate of Return (IRR)
The internal rate of return is the annualized discount rate at which the present value of a deal's cash flows equals zero, making it the time-weighted compound annual return on invested equity.