This is a topic I love to talk about, I mean why do people just automatically assume they are going to do a fully amortized loan (i.e. pay principal and interest)? The answer: that’s the way it’s always been done. Most owners don’t even consider the possibility of paying interest only. There are 2 main reasons why I think you should consider thinking outside the box and looking at your investment through a bit of a different lens.
- More cashflow.
This is the most obvious reason. I suspect the reason you bought an investment property is because you are looking for passive income. After all, investments are supposed to provide a return on your hard-earned dollars, why not maximize the cash you physically get? There are the rare cases that while some people are looking for cash flow, they make so much income from their day job that they need write offs and cash flow is more important for retirement. Even for those people, I still say consider interest only, you can’t write off principal reduction on your taxes so may as well have some extra cash to put to work for you.
- Principal reduction is minimal.
If you go with a fully amortized loan, about 30% of your payment goes toward principal reduction and it *very* gradually increases each month. It’s not until about year 12 that principal reduction becomes greater than the interest portion of the payment (and its highly unlikely you’ll ever keep a loan that long not to mention very few lenders offer more than a 10-year fixed). In addition, think about how useful the extra cash in hand could be. How much money could you make re-investing those funds? Say you get a $1,000,000 mortgage at 4%. The difference between a fully amortized payment and an interest only payment is $1,440.82 per month or $17,289.84 per year. Over 5 years, that is more than $86,000.
I’m a big fan of leverage. Now that doesn’t mean I think you should throw caution to the wind and over-leverage yourself. This may not be right for every investor on every deal but you also need to consider the reasons this may be the right decision for you. Your down payment is your principal reductionand you are looking for a return on those dollars invested.
The question is,
“Do you want to use that return on investment to pay down your loan or could those funds be put to better use elsewhere?”
Perhaps you need to invest money into your property to renovate. Having an interest only payment will help recoup the cost of those capital improvements. This will increase your property value thus increasing your equity. Maybe you want to buy other property, pay down more expensive debt (i.e. credit cards), there are really many factors to consider and you want to consider your full financial picture before committing to a loan.
Now, not all lenders are keen on interest only. In fact, some don’t offer it at all and many that do offer a maximum of 3-5 years of interest only. As an example, if you have a 7-year fixed, the loan may convert to principal and interest after 3-5 years. There are, however, some options for full-term interest only financing.
I would love to hear your feedback. Do you have interest only loans or have you ever considered it? If you are buying or refinancing your commercial or multifamily property and have questions, reach out and see how you can maximize your investment through getting the right loan to fit your goals.