An ordinary loan will be calculated so that, over the life of the loan, the full amount of the loan, both principal and interest, will be paid. This is called a fully-amortizing loan. In an interest-only loan, the monthly payments pay only the interest which is accruing; the payments do not reduce principal at all.

The advantage of an interest-only loan, of course, is that the monthly payments are lower than an ordinary loan. The disadvantage of such a loan, of course, is that the borrower never reduces his or her debt. No equity is built by such a loan; it simply treads water financially.

Interest-only loans can be sensible, if they are intended to be short-term. If, for example, a developer needs money to construct a property, but will have no income from the property until construction is completed, an interest-only loan makes economic sense. It reduces the developer’s carrying costs, when he or she has no income, but, assuming that the project is rented out or sold, there should ultimately be income, which can be used to pay an ordinary loan, which should be used to re-finance the interest-only loan.