What happens to cash flows received by IO investors as principal is paid down?

The cash flows received by interest-only (IO) investors decrease as principal is paid down because the payments they receive are solely based on the interest of the underlying principal amount. An IO investment is structured so that investors receive payments that represent the interest on a mortgage or a pool of mortgages, but not the principal repayment.

As the borrowers pay down the principal of the loans, the outstanding principal balance diminishes, which in turn reduces the overall interest income generated. For example, if an IO investor is receiving interest payments based on a mortgage with a $100,000 principal at an interest rate of 5%, their cash flows will be substantial at the beginning. However, as borrowers pay down the principal, the amount of interest received will also decrease because the interest is calculated on the lower remaining principal. Consequently, as the principal is paid down, the total interest income—and thus the cash flows—will drop over time.

This relationship illustrates why the cash flows received by IO investors decrease as the principal is repaid.