For real estate investors, minimizing costs is a key goal. While securing a low-interest rate is important, reducing cash outflows is equally essential. One way to achieve this is through an interest-only loan.
What is an Interest-Only Loan?
An interest-only commercial mortgage allows the borrower to pay only the interest on the loan for an initial period, typically up to 10 years. Unlike traditional loans that require payments toward both the interest and principal, interest-only loans delay principal payments. This results in lower initial monthly payments since the borrower is only covering the interest on the loan balance.
In practice, this can save borrowers money in the short term. For instance, a 30-year loan of $10 million with a five-year interest-only period may result in interest payments of $41,667 per month, compared to $54,486 per month in a traditional loan where both interest and principal are repaid.
How Do Interest-Only Loans Work in Commercial Mortgages?
Interest-only loans work by requiring the borrower to make payments only on the interest during the initial period, with no reduction in the loan principal. This allows the borrower to retain more cash for other purposes, such as property improvements or operational expenses.
These loans are common in construction financing, where the borrower may refinance the loan once the property is completed. They’re also popular with bridge loans, which are short-term loans used until the property is sold or refinanced at a lower interest rate.
Calculating Interest-Only Loan Payments
To calculate interest-only payments, multiply the loan balance by the annual interest rate, then divide by 12 to determine the monthly payment. Since the principal remains unchanged, the interest payments stay the same throughout the interest-only period until refinancing or a lump-sum payment is made.
Why Choose an Interest-Only Loan?
Interest-only loans appeal to borrowers in specific situations, such as when they need to acquire a property, renovate it, and refinance at a higher value later. These loans are also beneficial for development projects where the property doesn’t generate income until completed.
For real estate investors who plan to buy, renovate, and resell properties, interest-only loans help maintain higher cash flow during the renovation phase, providing financial flexibility.
Benefits and Risks of Interest-Only Loans
Interest-only loans offer several advantages, such as lower monthly payments and increased cash flow, enabling borrowers to invest in improvements or manage other business needs. However, these loans come with risks. Since the loan principal isn’t paid down, borrowers will need to refinance or make a balloon payment once the interest-only period ends. Additionally, once the interest-only period is over, loan payments will increase, potentially straining cash flow.
Interest-Only Loans vs. Conventional Loans
Conventional loans require monthly payments that cover both interest and principal, gradually reducing the loan balance. While this builds equity, it results in higher monthly payments compared to interest-only loans. With interest-only loans, the borrower enjoys higher cash flow initially, but faces the risk of larger payments in the future, as well as the need for refinancing.
Conclusion
Interest-only commercial mortgages offer short-term cash flow benefits, making them appealing to investors needing flexibility during the initial years of a loan. However, they also come with higher long-term risks and costs if the loan is held over time without refinancing. Investors should weigh these factors when deciding if an interest-only loan fits their financial strategy.