Interest-only promissory notes: how they work and when to use one

An interest-only promissory note lets the borrower pay just the interest for a set period, so the principal stays exactly where it started. When that period ends, the note either switches to regular payments of principal and interest or calls for the full principal in one lump sum.

The appeal is a low payment at the start. To see what it costs, take a $50,000 loan at 7 percent per year over five years and compare three ways to structure it.

The interest-only payment is $50,000 times 7 percent, divided by 12, which rounds to $291.67. The amortized rows use the standard payment formula, with the final payment adjusted by a few cents for rounding.

Look closely at the middle row. For two years the borrower pays $291.67 a month. Then the payment jumps to $1,543.85, an increase of $1,252.18 and more than five times the old amount. By the end of month 24, the fully amortized borrower would already have cut the balance to $32,064.51. The interest-only borrower still owes all $50,000 and now has three years, instead of five, to repay it.

The $1,543.85 figure is simply what it takes to repay $50,000 at 7 percent in 36 payments instead of 60. A shorter interest-only period softens the jump. With 12 interest-only months followed by 48 amortized payments, the later payment is $1,197.31, and total interest over five years comes to $10,971.02. That sits between the fully amortized loan and the 24-month version, so the length of the interest-only period is the lever to negotiate.

The bottom row ends in a single payment of the full $50,000. That structure carries its own set of problems, which we cover in balloon payments on a promissory note. The rest of this guide sticks with the version that converts to amortized payments.

An interest-only period makes sense when the borrower expects money to arrive later on a known schedule. A relative finishing a degree, a small business waiting out its slow season, and an investor renovating a house to sell are the usual cases. In each one, the borrower can show you where the larger payment will come from. If the plan amounts to hoping income rises, an amortized installment note is the safer choice for both of you.

Risks the borrower takes on

The payment jump is the obvious risk, and it arrives on a fixed date whether or not the borrower is ready. A missed payment after the switch usually puts the note in default, and many notes let the lender demand the whole balance at that point. A borrower who planned on a raise, a sale, or a refinance that has not happened yet faces that demand with the full $50,000 still owed.

The lender carries a mirror image of that risk. For two years the lender's money is fully out the door, and every dollar of principal depends on the borrower handling a larger payment later. Lenders who agree to an interest-only period often ask for a short written plan showing where the bigger payment will come from, and they keep it with the note.

The quieter risk is that the borrower spends real money and builds no equity. In the middle row, $7,000.08 in interest-only payments leaves the balance at $50,000. If the loan paid for property or equipment and its value falls, the borrower can owe more than the asset is worth. For that reason, lenders often pair an interest-only period with collateral, using a secured note that names the property backing the loan. The structure does not change how the rate is measured, so check it against the borrower's state cap with our usury limit checker.

A clear interest-only clause states the period, the starting payment, the switch date, and the new payment. Here is wording built on the middle row of the table.

"Beginning on [first payment date], Borrower shall make 24 monthly payments of accrued interest only, which at the original principal of $50,000 equals $291.67 per month. Beginning with the 25th payment, due on [date], Borrower shall pay 36 equal monthly installments of $1,543.85, which include principal and interest at 7% per year, until all principal and accrued interest are paid in full. Borrower may prepay principal at any time without penalty."

Write the 25th payment by number and by calendar date. A clause that says only "after two years" leaves room to argue about whether the switch happens at month 24 or month 25.

What the lender reports to the IRS

Interest you receive on a private note is income. The Internal Revenue Service (IRS) says in Topic 403 that most interest is "taxable income in the year it becomes available to you," and it requires you to report all taxable interest on your federal return whether or not a Form 1099-INT arrives.

An interest-only note front-loads that income. In the example, the lender collects $3,500.04 in interest in each of the first two years, or $291.67 times 12. On the fully amortized version, first-year interest comes to $3,225.80, because the balance starts shrinking with the first payment. Keep a ledger that splits each payment into interest and principal, since the return of your own principal is not interest income.

Sources

• IRS Topic 403, Interest received