Interest only loans have become an increasingly popular financing option for real estate investors looking to purchase investment properties. By only requiring interest payments initially, interest only loans can provide greater cash flow flexibility compared to traditional amortized loans. However, they also come with unique risks that investors should fully understand. This article will provide an in-depth look at how interest only loans work for investment properties, their pros and cons, key terms to understand, and tips for evaluating if an interest only loan is suitable for your real estate investment strategy and risk tolerance.
Interest only loans can provide positive cash flow for investment properties
One of the biggest potential benefits of interest only loans for real estate investors is improved cash flow, especially in the early years of the loan. By only requiring payment of interest initially and deferring principal payments, monthly loan payments are lower compared to a traditional amortizing mortgage. This frees up more cash that can be used to cover other property expenses, capital improvements, vacancies, or simply help generate positive monthly cash flow. For real estate investors focused on cash-on-cash returns, using an interest only loan on an investment property can boost these returns during the interest only period. However, it’s important to note that once the interest only period ends, payments will increase to include principal and may result in negative cash flow if rents don’t also increase.
Interest only loans allow for greater leverage and lower down payments
Given their potential to provide better cash flow, interest only loans are often attractive options for real estate investors looking to maximize leverage and minimize their down payments on investment properties. By only requiring interest payments initially, investors may qualify for a higher overall loan amount compared to a traditional mortgage based on just covering the interest payments. This allows real estate investors to control more properties with less of their own capital invested. However, higher leverage also brings greater risks should the investment property decrease in value or rental income. Investors should ensure they can still make the higher principal and interest payments after the interest only period ends.
There are unique risks to understand with interest only investment property loans
While interest only loans offer benefits like better cash flow and increased leverage for real estate investors, they also pose some unique risks to consider:
– Payment shock risk when principal payments start – After the interest only period, payments will jump up significantly to start covering principal. Investors must ensure rental income can support the higher payments.
– Extension risk on adjustable rate loans – If interest rates rise significantly, investors may not be able to refinance into a new loan and be forced to start making principal and higher interest payments.
– Less equity build up over time – With no principal being paid down, interest only loans build equity slower compared to amortized mortgages.
– Potentially higher interest rates – Interest only loans often come with slightly higher interest rates given the added risks to lenders.
Weighing these risks and mitigation strategies is key when evaluating using an interest only investment property loan.
Interest only periods, loan terms, and fixed vs adjustable rates impact suitability
When considering an interest only loan for an investment property, there are some key factors investors should assess to determine if it aligns with their investment strategy and risk tolerance:
– Length of interest only period – Typical periods range from 3-10 years on investment property loans before principal payments start. Choose based on projected cash flow needs.
– Overall loan term – Most interest only investment property loans have 30 year total terms. Ensure the loan doesn’t expire before your exit strategy.
– Fixed vs adjustable interest rates – Adjustable rate interest only loans pose extension risk when payments recast if interest rates rise. But fixed rates are often higher.
– Amortization term once interest only period ends – A longer amortization term can help keep payments affordable when principal payments begin.
Thoroughly understanding these factors will help real estate investors evaluate if an interest only loan properly balances benefits and risks for their specific investment property situation.
For real estate investors looking to maximize returns and leverage investment property purchases, interest only loans can be an attractive financing option but also pose unique risks. By understanding key factors like the interest only period, potential payment shock, lack of equity build up, and extension risk, investors can better assess if an interest only mortgage aligns with the financial goals and risk tolerance levels of their overall investment strategy.