Interest-only, amortizing, or fixed principal

Every loan charges interest on the principal still outstanding. The rate and the term set how much that costs per period. What the repayment structure decides is how quickly the principal is returned, and therefore how much interest accrues before it is.

Use one example throughout: $25,000 at 6.00% a year, 36 monthly payments. Under each structure the monthly interest is 0.50% of the balance. What differs is the principal in each payment.

The payment is the same every month, $760.55. Inside it, interest starts at $125.00 and principal at $635.55. Each month the balance falls, interest falls with it, and principal takes up the difference. By the final month almost the whole payment is principal. Total interest over the three years is about $2,379.80.

This is how car loans and mortgages work, and it suits a borrower who repays from a salary. The payment is predictable, the loan is fully repaid at the end, and there is no large sum to find on the last day. The guide to how an amortization schedule works walks through the arithmetic row by row.

Each payment covers only that month’s interest. The balance never falls, so the interest never falls either: $125.00 a month for 35 months. The 36th payment is the last month’s interest plus the entire principal, $25,125.00. Total interest is $4,500.00, nearly double the amortizing figure, because the full $25,000 is outstanding for the whole term.

That final payment is a balloon payment. An interest-only structure makes sense when the borrower expects a lump sum before maturity: the sale of a property, a bonus, a business distribution, an inheritance, or a refinancing with a bank. It is a bridge, and the loan is only as sound as the plan for the bridge’s far end.

The low monthly figure is attractive and misleading. The borrower is paying rent on the money, not paying it back. A lender who agrees to interest-only terms should ask what will produce the $25,000 and when, and write that answer into the loan file. The interest-only calculator shows the monthly cost and the balloon for any amount and rate.

The same amount of principal is repaid every month, $25,000 ÷ 36, or $694.44. Interest is added on top, computed on the falling balance. The first payment is $694.44 plus $125.00, or $819.44. The last is about $698.07. Payments fall by a few dollars each month. Total interest is about $2,312.50, the lowest of the three, because principal comes back fastest.

Fixed principal suits a lender who wants capital returned steadily and a borrower who can carry the higher early payments. It is common in business and investor loans, where the borrower’s cash flow is expected to be stronger at the start than a salaried person’s, or where the lender is relying on the principal being back sooner rather than later.

On the $25,000 example, the structures compare as follows.

• Amortizing. 36 payments of $760.55. Total interest about $2,379.80. No balloon.
• Interest-only. 35 payments of $125.00, then $25,125.00. Total interest $4,500.00. Balloon of $25,000.
• Fixed principal. First payment $819.44, falling to about $698.07. Total interest about $2,312.50. No balloon.

The order of total interest, lowest to highest, is fixed principal, amortizing, interest-only. That is the order in which principal is returned, fastest to slowest. The rate did not change. The term did not change. Only the timing of the principal did.

A balloon is a known date on which a known sum is due. The risk is not the size of the sum. It is the plan for raising it failing, or being late, in the month it is needed. A lender and borrower who agree to a balloon should settle three points at the outset.

• The source. Name what will pay the balloon. If it is a property sale, note the expected date and what happens if the property has not sold.
• The fallback. Decide now whether the note may be extended, on what terms, and whether the lender would accept conversion to an amortizing schedule from the balloon date.
• The warning. Agree that the borrower will confirm, three months before maturity, that the source is on track. A balloon that goes wrong usually goes wrong silently.

If the fallback is an extension, write it into the note as an option with its own rate and term, rather than leaving it to goodwill at a moment when goodwill is under strain.

Paying principal ahead of schedule reduces interest under every structure, because interest is charged on what is owed. The effect is largest on an interest-only loan, where every dollar of early principal removes 0.50% a month for the rest of the term. A borrower on an interest-only note who receives part of the expected lump sum early should put it against principal at once, if the note allows it.

Check the prepayment clause. Most private notes permit prepayment without penalty. Some charge a fee, usually a percentage of the amount prepaid, to compensate the lender for interest they expected to earn. Whether that is reasonable depends on who needed whom: a lender who structured their own finances around the income has a case for it, and a relative helping out generally does not.

Ask what the borrower’s money will look like over the term. Steady income with no lump sum in sight points to amortizing. A lump sum arriving before maturity, with a credible source, points to interest-only, with the balloon planned as above. Strong early cash flow and a lender who wants capital back quickly points to fixed principal.

Compare structures only at the same rate and the same term, and compare total interest alongside the payment pattern. A lower monthly figure is not a cheaper loan. It is usually a more expensive one with the cost moved to the end.