Interest Only Loans – When They Make Sense and Why
Most homeowners and investors are familiar with a standard loan – one in which an amount of money is borrowed, and payments are made on both the interest and principal. However, this is not the only option. Interest-only loans, while less common, can be valuable tools in the right hands, particularly from an investment standpoint.
Interest-only loans are a niche product, and, in many cases, will not be the right choice for everyone. But under the right circumstances, it is possible to benefit from leveraging an interest-only option. So, what is an interest-only loan, how does it differ from a regular lending option, and when is it the most beneficial choice for buyers?
What Are Interest-Only Loans?
Interest-only loans are loans in which only interest is paid at the start of a borrowing period. This period usually spans five to ten years but can vary based on the terms of the loan. Then, once this period comes to an end, the borrower will commence making payments on the principal or will refinance to another mortgage. The name is a bit of a misnomer; these loans have an interest-only period but there is still principal to be repaid before a mortgage is completely paid off.
Sound like an odd setup? It is; the primary benefit of this kind of loan is the flexibility of having the option to make low monthly payments in the years directly following a property purchase. Buyers do not accrue equity with every payment they make, as in a typical mortgage, but, in exchange, they are only responsible for the smallest portion of a general loan payment – the interest. In a way, the interest payment functions somewhat like paying rent to the bank responsible for the mortgage.
For example, take a conventional 30-year mortgage of $650,000 with a 5% interest rate. Assuming that no Homeowners Association Payments, PMI or escrow costs are built into the value of the loan, monthly payments should be a little more than $3,500 a month. Just over $2,700 of this is principal, while the rest is interest. In an interest-only scenario, loan payments would be around $2,700 a month – an $800 per month savings – for the first five to ten years of repayment. For those with concerns about cash flow, putting off principal payments in favor of lower interest-only payments can be an appealing situation.
The Downsides of Interest-Only Loans
Interest-only loans are not common for a reason, and that is because their benefits are not applicable to many people. Rates on these loans tend to be higher than a conventional mortgage, which means a higher total repayment amount at the end of the loan term. Further, paying interest without touching the principal means that you are not gaining equity; you are simply paying for the privilege of not making a more sizeable investment until later in the loan term.
When Interest-Only Loans Make Sense
Keep in mind that interest only loans do not mean that a borrower is unable to make principal payments. In fact, an “interest only” loan is an “interest only option.” That means a borrower has the option to make only an interest only payment. They are not required to pay any principal, but they can! So having an interest-only option is an excellent choice for someone who would like some flexibility and has the option to make less than a full payment when needed.
Interest-only loans are not a wonderful choice for everyone, though. If a borrower does not make a full payment, clearly, they are not reducing their debt. However, that does not mean interest only loans cannot be an amazingly effective tool. These are a few scenarios in which an interest-only loan could be a smart financial move – and why.
Investors in Need of Flexibility
There is great value for investors in the interest-only loan option, so those looking for low-cost monthly payments and increased flexibility may want to keep this opportunity in mind.
An example could be an investor buying a property below market value that doesn’t cash flow with a full mortgage payment. However, they could cash flow (or even be negative cash flow) with an interest only payment, while improving the value of the property and gaining equity, then refinance or sell the property after holding it for a period of time and make more money in the appreciation than they would have gained by making a full payment. In this way, Interest Only loans can be a great tool for real estate investors to expand their investment portfolio.
When there are multiple investment-related plates in the air, keeping cash outflows as low as possible can be an important objective, particularly when investing in multiple properties at once. Using an interest-only mortgage loan can make it possible to purchase property without adding hundreds or thousands of dollars to monthly expenses, keeping cash flow free for other investment activities. This is somewhat the opposite of the prior scenario in which an investor buys a property with plans to pay it off with the sale proceeds of a current investment; instead, investors buy property with an interest-only mortgage to keep cash available for other investment opportunities in the future. This can be prudent in a competitive market when acting fast is a priority, or for investors who have their sights set on projects that are not yet available.
In addition, this can be a good way to keep cash flow free when rehabbing a rental property. If you purchase a property to rehab and rent out, there will likely be high expenses immediately after purchase before cash inflows from rental payments will begin. An interest-only loan ensures that monthly payments are very low in the first few years, resulting in more money available for the renovation process. There are specific types of loans available for specific types of investment purchases, however, interest-only is a great tool at your disposal.
Most people plan to own a property long-term, or, at minimum, for at least seven years. However, for buyers who do not plan to stay put for very long an interest-only loan can mean low costs and a negligible impact to an investment. If there is not time to gain substantial equity, the potential loss of a few thousand dollars of investment may not mean much in the big picture when low spending today is the priority.
This is particularly true for those who simply want a less expensive way to live while moving from place to place. In many cases, the interest portion of a mortgage loan will be less than rent for a comparable property, particularly in high demand areas, making day-to-day life more affordable. This is not an orthodox strategy, but as the cost of housing continues to rise in many areas of the country, especially in California, interest-only loans may become a more popular avenue when a conventional mortgage – or local rent prices – stretches the limits of affordability. When the potential equity to be gained is negligible, capitalizing on a more affordable alternative can be compelling. Even factoring closing costs and the time, this strategy can work very well.
Most people get paid every other week or twice a month, but some jobs function differently. Commission-based jobs, for example, may result in periodic lump-sum payments rather than reliable income in regular intervals. Those who make enough money to afford a mortgage but do not receive payment on a predictable schedule may want to keep monthly payments low to avoid spiraling expenses.
For those who make a comfortable base income with the additional benefit of large lump-sum payments, like extra bonuses or stock compensation, an interest-only loan can be a way to minimize expenses while preparing to pay off a mortgage in a lump sum in the future.
Depending on how this is handled, paying off all or most of a mortgage in one instance can result in savings in the long run; a few years of paying only interest (even at a higher initial rate) while getting a high-paying career off the ground or waiting for a large investment to yield dividends can allow for a big payment – or a few big payments – which can greatly reduce the principle outstanding before payments on principle are scheduled to begin. This can be a risky game, particularly if the availability of money to put down in the future is not guaranteed, but under the right circumstances, an interest-only loan is a strong strategy.
The Purchase of a Second Property
Another scenario in which an interest-only loan is a strong point of consideration is the purchase of a second property – particularly if this property is intended to be paid back later with the sale of an investment property or primary property in the years to come. A couple purchasing a retirement property on the cusp of changing needs, for example, may want to use an interest only-loan to keep initial expenses low while sorting out affairs and planning. Then, upon the sale of the primary residency, the loan can be repaid as normal, either with a lump sum payment or several larger payments over time. This is a popular strategy for those who want to transition a vacation property into a full-time residence once kids are grown and housing needs simplify.
This approach to property purchase can work in an investment capacity as well. Say a great fix and flip or rental property comes onto the market, but most of your funds are already in use renovating a property purchased in the years or months prior. There is no way to sell the property you are currently rehabbing in time to use the proceeds for the purchase of the new property, but an interest-only loan (and other loan options provided by Westpark Loans) can allow you to make an affordable purchase without as much monthly cash expense. Then, you flip your original investment property, you can put the principle into your new project.
Considering an Interest-Only Loan
If the idea of paying solely interest for a few years sounds compelling, you are not alone. However, this approach can cost far more in the long run, so it is not a strong financial move for most homeowners.
If you are considering an interest-only loan, you need to make sure you are considering it for the right reasons. Before putting pen to paper to sign for an interest-only loan, ask yourself these questions:
- Is there a long-term benefit to saving money in the first years of a loan?
- Do you have a good way to pay on the loan once principal payments are due? Are you confident with a refinance?
- Do you have a way to pay off the loan in large part or in full prior to principal payments coming due?
- Is this kind of loan essential to investment ambitions or quality of life rather than convenience?
- Are other alternatives for a mortgage?
- Is this a wise investment strategy rather than an option that seems cheaper or easier?
As with any investment option, it is about picking the best option, not the most convenient. Prior to moving forward with an interest-only loan, make sure it is truly the right option for your property rather than effectively kicking the can down the road.
There are lots of investment lending options to consider, and interest-only loans are among the least utilized. While there are few scenarios in which an interest-only loan is the best path forward, it can be a great way to save money in the short term while allowing for flexibility down the road. This will not be right for everyone or under all circumstances, but every now and then, cost savings now can mean big benefits later. Speak to a Westpark Loans representative to guide you through interest-only loan options and other loan types that may work best for you.