Defintion of an Interest Only Loan
An interest only loan specifies that only interest payments are required during the life of the loan. No principal payment is required until the loan comes due.
Example of an Interest Only Loan
Assume that on July 1, a company borrows $100,000 with an annual interest rate of 12%. The interest for each month is to be paid on the last day of the month. No principal payment is required until the loan comes due in two years.
On July 1 the company records the loan as follows:
- Debit Cash for $100,000 (the proceeds from the loan)
- Credit Notes Payable for $100,000 (the principal amount that is due in two years)
Since the principal balance of $100,000 will not be reduced until two years later, the note payable is reported on the balance sheet as a noncurrent or long-term liability for the first year. During the second year the principal balance is reported as a current liability.
If the current month's interest is paid on the last day of each month, there will be no interest liability reported on the end-of-the-month balance sheets. Each month's payment of interest requires a credit to Cash and a debit to Interest Expense, which is reported on the monthly income statement.