Will a lender give an interest-only period, and how much amortization is normal?

Why the schedule can matter more than the rate

Debt service is interest plus scheduled principal. Owners shopping a loan tend to compare rates, but on a loan repaid over five to ten years scheduled principal is a large share of each payment, on the shorter schedules often more than the interest, and it is set almost entirely by how many years the lender gives you to repay. Every coverage test a lender runs, from SBA's minimum to a bank's covenant, divides cash flow by that combined payment. See DSCR vs FCCR for how the two common tests are built.

Take a business with 1,500 a year of cash flow available for debt service that borrows 6,000, with interest of 600 in the first year. The only thing that changes below is how fast the principal is repaid. The figures use the first year and ignore the interest that falls as the balance comes down.

Now compare the rate. A rate increase that adds 60 a year of interest is a tenth of the gap between the five-year and ten-year schedules. The five-year loan is the cheaper loan over its life, because less interest accrues on a balance that shrinks faster, and it is also the one this business cannot carry. That is why an owner with a tight coverage ratio should negotiate the schedule before the rate, and why how much debt a business can carry depends as much on term as on earnings.

A cheaper loan the business cannot service is not cheaper. Run coverage on the payment, not the rate.

What each kind of lender expects

Amortization is not a matter of one lender being generous and another stingy. It follows from how each lender funds itself, what it is lending against and where it sits in the capital stack.

Two points follow. First, a bank term loan and an SBA loan usually take more cash each year than a unitranche loan of the same size, even when their rates are lower. Second, the unitranche borrower is making a promise to refinance. The senior vs unitranche comparison and the page on excess cash flow sweeps explain how fund lenders recover principal when the business does well instead of on a fixed schedule.

Real estate is the case where term and amortization part company most often. A bank may write a loan with a short term on a much longer repayment schedule, which keeps payments low and leaves a balloon. Loan term vs amortization period walks through that structure, and the fully amortizing 25-year real estate maturity of a 7(a) loan is one way to avoid a balloon altogether; 7(a) vs 504 compares the two SBA routes for property.

When lenders grant an interest-only period

Lenders give interest-only periods when there is a specific reason cash flow will be lower at the start than later, and a plan that shows when it recovers. The common cases:

• An acquisition's transition. A buyer taking over a business, or a platform folding in an add-on, may get a few months of interest only while systems, staff and customers settle.
• A build-out or construction. A new location, a plant expansion or a real estate project that produces nothing until it opens.
• Equipment before it earns. Machinery delivered and installed ahead of the contract it will serve.
• Seasonal businesses. Some lenders set payments that skip or shrink in the off months, instead of a single period at the start.
• A restructuring. A lender working with a struggling borrower may allow interest only while a plan takes hold, usually in exchange for tighter terms. See forbearance agreements.

Every month of interest only has a cost that shows up later. The loan still has to be repaid by its maturity, so the remaining payments are larger, or a balance is left at the end. Lenders will usually want to see coverage on the full amortizing payment, not just the interest-only one, because that is the payment the business will carry for most of the loan's life. Expect the period to be short, stated in the loan documents, and ended automatically.

On SBA loans, some lenders allow a short interest-only period at the start where the business needs time before it produces cash, such as a new location. It is less common on the purchase of a going concern, which is expected to generate cash from the first month, and the loan still repays in full within its maturity. For an existing loan, asking for interest only or a re-amortization is a different conversation, covered separately.

The trade you make with light amortization

Light amortization buys headroom now with a balance later. In the example above, the loan paying 60 a year still owes 5,700 after five years. Whoever holds the business then has to refinance that balance on whatever terms the market offers, which is why fund lenders underwrite leverage at maturity as well as coverage today. Refinancing ahead of a balloon maturity explains what happens when the timing goes wrong.

Full amortization does the opposite. Each year the balance falls and leverage falls with it, even if earnings stay flat. That paid-down balance is capacity: it is what lets a company borrow again for the next acquisition, refinance on better terms or ask for the owner's personal guarantee to be released. Owners who plan to hold a business for a long time often do better with a heavier schedule they can afford than a light one they will have to refinance.

Light amortization also tends to come with a higher rate, because the lender is carrying more risk for longer. Comparing offers therefore means comparing all-in cost across the years you expect to hold the loan, not the monthly payment. The page on interest rate vs all-in cost sets out how.

What to ask for in the term sheet

• Match the schedule to what is financed. Goodwill and working capital on a shorter schedule, equipment over its useful life, real estate over the longest schedule available. A blended loan can split amortization by use.
• Test coverage on the first full year of amortizing payments. If there is an interest-only period, run the test on the payment that follows it.
• Ask how interest only ends. Does the loan re-amortize over the remaining term, step up in stages, or require a catch-up payment?
• Read the covenant definitions. Scheduled principal usually counts in a fixed-charge or debt service test; voluntary prepayments usually do not. That affects how much headroom a light schedule really gives.
• Ask how prepayments apply. Prepayments applied to the last installments leave near-term payments unchanged; applied pro rata, they lower them. Check any prepayment penalty at the same time.
• Look at the balance at maturity. If it is large, plan how it will be refinanced before signing.

Transparent's financing model shows debt service and coverage year by year under each structure a lender might offer, so the schedule is visible before any term sheet arrives. It is part of the lender package, and how we underwrite explains the coverage tests it runs.