Every commercial real estate transaction is slightly different. As a result, lenders have a variety of products that are designed to meet as many of the borrower’s needs as possible. One of these products is an interest only loan.
In this article, FNRP explains what interest only loans are, when they are appropriate, and the benefits and risks of an interest only loan.
What is an Interest Only Loan?
An interest only loan is a commercial mortgage whose monthly payment consists of only the interest charged by the lender. Interest only loans are different from a traditional amortizing loan, whose payments consist of both principal and interest.
Example of Interest Only Loan vs. Traditional Amortizing Loan
To illustrate the difference in how the payments are calculated for interest only loans vs. traditional amortizing loans, an example is helpful.
Assume that a borrower is considering purchasing a multifamily commercial property with a $1,000,000 loan that has an interest rate of 6% and an amortization period of 20 years (240 months). The amortizing payment is calculated using a spreadsheet or financial calculator and it comes out to $7,164 per month.
In the first month of the loan, $5,000 of the payment goes towards interest and the remainder ($2,164) goes to principal, which reduces the loan balance to $997,854 ($1,000,000 – $2,146). With each successive payment, the portion allocated to interest goes down a little bit and the portion allocated to principal goes up, reducing the loan balance along the way.
The calculation of the interest only payment is much simpler. It is the loan balance of $1,000,000 multiplied by the interest rate and divided by 12 months. For the loan above, the result is $5,000 per month. But, this only pays the interest. The loan balance does not go down with each payment.
Depending on the specific loan terms, the interest only period for the loan may be temporary – say 12 months – or it can last for the entire loan term. Interest only loans and/or loans with at least some period of interest only payments are offered by banks, credit unions, insurance companies, conduit lenders, and government agencies like the FHA, Fannie Mae, or Freddie Mac.
When Are Interest Only Loans Appropriate?
In general, the most appropriate use case for an interest only loan is when there is a gap between the time an investor purchases (or constructs) a property and the time it starts to produce a stable stream of rental income. The two most common situations in which this occurs is in construction and value add projects.
When an investor is constructing a property, they need to conserve as much cash as possible during the construction phase. As a result, a typical construction loan program includes a pre-funded interest reserve account from which interest only payments are deducted while the property is under construction. Once the property is complete and occupied with rent paying tenants, the payments may convert from interest only to principal and interest to align with the property’s increased income.
In a value-add project or one with heavy renovations, the concept is the same. The investor has a high upfront cost to renovate the property and needs to use their capital for that purpose. By getting a loan with interest only payments, the investor can conserve capital until renovations are completed and the property is producing enough income to make amortizing payments.
Other situations where interest only loans may be appropriate include purchases of properties with high levels of vacancy or when the property will be held for a short period of time before being sold. In the first case, the borrower would make interest only payments while they lease up the property to stabilization. In the second case, the loan with interest only payments acts as a “bridge loan” until the property is sold to another buyer.
Benefit of an Interest Only Loan
From the examples above, it should be clear that the major benefit of an interest only loan is that the reduced loan payments allow the borrower to conserve their capital until:
(1) the property’s cash flows can support an amortizing payment;
(2) construction and/or renovations are complete; or
(3) a property is refinanced or sold.
Risks of an Interest Only Loan
While interest only payments may seem like a great deal, this type of loan also comes with three material risks.
1. Interest Only Payments Tend to Be Temporary
First, interest only payments tend to be temporary with a relatively short term (less than 24 months). When the interest only period is complete and the payments convert to amortizing, there can be a sudden and significant increase in the loan’s required payments. If the property’s cash flows are unable to support the larger payment at the time of conversion, the borrower could default.
2. Doesn’t Reduce the Loan’s Balance
Second, interest only payments do not reduce the loan’s balance. If the value of the property were to decline, real estate investors could find themselves in a position where they owe more on the property than it is worth. If the investors were in a position where they were forced to sell the property, they would have to do so at a loss. For example, assume an individual borrows $1,000,000 to purchase an office building at an 80% LTV (which means they made a 20% down payment). After three years, property values have declined to $900,000 and the loan-to-value ratio has increased to 111%. If the investors found themselves in a position where they had to liquidate the property quickly, they would lose $100,000 in the deal.
3. “Balloon Payments”
Third, because interest only loans do not reduce the principal balance, they come with a “balloon payment” at the end of the term. If the borrower is unable to meet this repayment requirement – through payoff or refinance – they could quickly find themselves in default on their investment property.
For these reasons, business owners and investors should carefully weigh the risks and benefits before entering into an interest only transaction.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
When purchasing a property, we work with our partner financial institutions and commercial lending experts to find a loan structure that works best for the needs of the property. On occasion, this may include an interest only loan.
To learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.