Interest-Only Loan

The definition and the risks both come from primary documents.

12 CFR 1026.18(s)(7)(iv) defines interest-only to mean that, under the terms of the obligation, one or more periodic payments may be applied solely to accrued interest and not to principal, and an interest-only loan as one that permits such payments. The definition sits in the consumer disclosure rules, but the mechanics are the same for commercial debt.

A CMBS prospectus filed with the SEC in 2025 explains the risk to investors: many of its loans require only interest for part or all of their terms, and an interest-only provision leaves more principal outstanding at maturity, making the final payment harder to meet. Repayment then depends on the borrower's ability to refinance or sell.

The OCC's Commercial Real Estate Lending handbook makes the same point from the lender's side. Interest-only terms raise debt service coverage and lower the chance of payment default, but increase the loss if default happens and the risk at maturity. It notes that bank interest-only tenors are usually three to five years at most, and that the property should still qualify as if the loan were amortizing.

A hypothetical: the amortization cliff.

Hypothetical figures: a $2,000,000 loan at 6% costs $10,000 a month while interest-only. When the interest-only period ends and the loan starts amortizing over 30 years at the same rate, the payment rises to about $11,990, roughly 20% more, with no change in rent. A property that comfortably covered the interest can be tight once principal is due.

The balance also stays at $2,000,000 for as long as payments are interest-only. If you sell during that time, the debt you shed is the full original amount, and your replacement must carry at least that much debt, or you must add cash, to avoid net debt relief. Run your own numbers with your CPA.

It bites for DST investors, whose trust cannot change the loan.

Under Rev. Rul. 2004-86 a trust that wants its owners treated as holding real property may not renegotiate or refinance its acquisition debt. Whatever interest-only period the sponsor negotiated at the outset is the one the trust lives with, including the step-up in payments when amortization starts, which can reduce distributions.

Read the loan summary in the offering documents for the interest-only period, the amortization schedule and the maturity date, then weigh them with DST leverage and interest rate risk and how reliable DST distributions are. How the balance on an interest-only loan affects your own debt replacement is covered in replace the mortgage or add cash.