Small businesses often need capital to navigate a range of business challenges. While there are many small business loan options available, you may not have heard of interest-only small business loans. Interest-only commercial loans can be used for a variety of business needs, from equipment loans to commercial mortgages.

In this article:

• How an interest-only loan works
• Advantages and risks of interest-only commercial loans
• Short-term financing alternatives to interest-only commercial loans

What is an Interest-Only Commercial Loan?

An interest only loan is a loan in which the borrower only pays the interest payments on the loan amount over a pre-agreed period of time. At the end of the loan term, the untouched principal is dealt with, either by paying it off with a balloon payment or making another arrangement, like taking out another loan or working out a more traditional repayment plan.

By making interest-only payments, borrowers retain some short-term flexibility, which can allow them to refinance or consolidate other debt, or use the funds as a bridge loan. The interest-only period may extend the overall life of the loan and doesn’t decrease the principal loan balance, but it does lower your payments in the meantime.

Interest-only commercial loans are less common on conventional loans, but are often used by commercial real estate investors who need a commercial property loan to finance multifamily properties, but won’t begin seeing a return on investment right away. However, there are many more applications than just real estate investing.

Benefits of Interest-Only Commercial Loans

From construction loans to term loans, businesses may find that they can negotiate an interest-only period on many types of loans. However, these loans are riskier for lenders, so they’re not common. Some of the primary benefits of interest-only commercial loans include:

• Lower monthly payments: Traditional loan payments are applied toward both interest and payments towards the loan principal. Interest-only loans have lower monthly payments over the loan term because they don’t include regular payments towards the principal. This frees up cash flow and minimizes overhead costs while still gaining the necessary financing. Commercial interest-only loan rates might be higher through the end of the interest-only period, but that may be a worthwhile tradeoff if you expect to bring in more money soon.
• Borrowing flexibility: Because you’re only paying the interest at first, it’s possible to borrow larger amounts of capital and still be able to afford the monthly payments. This is especially useful for capital-intensive investments like commercial real estate loans and/or new equipment your business will need to succeed.
• Seasonal planning: Businesses impacted by seasonality may find that interest-only commercial loans are useful ways to keep the doors open in the offseason. As your revenue ebbs and flows throughout the year you can start to make extra payments towards the loan during your busy seasons and get by with lower payments during slower seasons.

Risks of Interest-Only Commercial Loans

Lenders are not the only ones shouldering risk with an interest-only loan. Small business owners should be aware of some important risks, including:

• Depreciation: Some major business purchases, like equipment, are vulnerable to depreciation. If you’re only paying interest on an equipment loan, the asset is losing value before you’ve even started paying for it, which may forfeit its value as collateral and put your business at risk of being on the hook for loan repayments.
• Prepayment penalties: If you’re trying to chip away at the principal while taking advantage of a lower monthly payment, you may be out of luck. Some interest-only commercial loans include prepayment penalties and fees when borrowers try to settle their loan before the end of the loan term. Make sure to check for prepayment penalties in your loan’s terms before adopting a repayment strategy.
• Large loan principal: At the end of the interest payment term, you’ll still have to pay off the principal. This can be risky. If your revenues haven’t grown to the point at which you can afford to pay off the principal or afford traditional monthly payments and haven’t made any necessary arrangements, that’s a problem. Before committing to an interest-only loan, make sure that you have a plan in place to deal with the principal.

How to Get an Interest-Only Commercial Loan

Both traditional lenders like banks and online lenders may offer interest-only commercial loans. Some financial institutions only provide interest-only loans to specific industries or as part of specific loan programs. Interest-only small business loans tend to be risker for lenders, so the requirements for credit scores and down payments tend to be higher, and you may have to start with a higher interest rate.

If you think an interest-only commercial loan is right for your business, spend some time shopping around, strategizing, and comparing loan products. You may consider working with an accountant to ensure your net operating income will improve enough to pay off the loan principal at the end of the interest-only period and consider prequalifying to get an idea of loan terms before locking anything in.

Alternatives to Interest-Only Commercial Loans

There are many financing options that can serve as short-term financing. If an interest-only loan isn’t right for your situation, here are some alternatives to explore:

• Small Business Administration (SBA) loans: SBA loans are a great option for long-term financing. Backed by the US Small Business Administration, these loans offer low interest rates, low down payments, and long repayment terms. Lenders feel more comfortable lending through the SBA loan guarantee programs, and these loans can be used for a variety of business needs. The SBA offers several short-term financing loan programs.
• Equipment loans: Purchasing equipment through equipment financing options will allow you to use the equipment now and pay it off over time. Often these loans will use the equipment purchased as collateral, which leaves other assets free as you pay back the loan.
• Business Line of Credit (LOC): A line of credit can be used by a business owner to fund various business expenses flexibly. These can be helpful during short-term cash flow gaps during slower seasons. Some financing companies even offer interest-only business lines of credit to provide even further flexibility.
• Merchant cash advances (MCAs): In an MCA, a provider pays a borrower a lump sum of money upfront in exchange for a percentage of future credit card or debit card sales. The borrower repays a percentage of sales in frequent installments — sometimes daily or weekly — until they’ve reached a total repayment amount, determined by a factor rate.

Final Thoughts

Interest-only commercial loans offer business owners the flexibility of lower monthly payments in the short term, but at the cost of not paying anything towards a loan principal. There are both advantages and risks to this, and interest-only small business loans should really only be used if you expect that the loan proceeds will lead to a significant increase in net operating income quickly.

FAQs about interest-only commercial loans

What is an interest-only loan?

An interest-only loan is one in which the borrower only pays interest for a certain period of time, rather than paying down the loan principal. At the end of the interest-only period, the borrower must repay the loan principal as a balloon payment or through another financing plan.

Can any business use an interest-only loan?

Technically, any business can use one, but it’s always subject to lender approval. Interest-only commercial loans are most common in the real estate and development industry because borrowers expect to receive large influxes of cash from rent, property sales, or grants from the U.S. Department of Housing and Urban Development (HUD) or other government agencies.

How long is an interest-only period?

It depends on the agreement with the lender, but commercial mortgages with interest-only periods tend to last between five to ten years.

What are alternatives to an interest-only loan?

Some other short-term financing options may include certain SBA loan programs, interest-only business lines of credit, equipment loans, or merchant cash advances.

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