Most real estate investors want to hit the ground running as quickly as possible. The more properties they can get ahold of, the better. But then all of a sudden they realize they’re on the hook for multiple, monthly mortgage payments and not enough cash flow to stay afloat. So how do savvy investors do it? They use interest-only loans for real estate investments.
Interest-only loans are mortgages where all payments are used to pay only the interest and not the principal. This strategy is often used for investors with multiple properties and want to allocate the money, which would usually be put towards multiple principals instead of one principal. The payments then work as a debt snowball and get one mortgage paid off quickly.
That’s just a high-level overview, so don’t worry if it feels like your head is spinning. Keep reading below because I dive into how interest-only loans work and why they can be a smart strategy for investors. Plus, I’ll get into the pitfalls you need to avoid and why this might not be the best method for all investors. Let’s dive in.
A Quick Guide to Mortgage Loans
Before we go into the nuances behind interest-only loans, I want to make sure you understand how it differs from your standard mortgage. The world of financing for home loans could be a whole book in itself. Rather than bore you to death, I’m just going to give a high-level view of what you can expect from an interest-only loan if you’ve only ever dealt with standard mortgages.
How a Standard Loan Works
With your regular, run-of-the-mill mortgage, you agree to a long-term loan that’s usually around 30 years. Your 30-year mortgage will have a fixed rate which is typically pretty low, though it can vary based on things like your credit history, income, etc. For the most part, your interest rate will be less than that of a short-term loan or a credit card.
At the beginning of that 30-year contract, most of your payments will go towards paying off the interest instead of the principal (the original amount borrowed from the bank). Let’s say your mortgage payments are $1,000 every month. For the first few years, something like $850 will go towards the interest, and $150 will go towards your principal.
As time moves on, the scale tips, and your payments begin to go more towards principal and less towards interest. So when you’re in, say, year 25, $850 of that $1,000 goes toward the principal, and $150 knocks out the last of the interest.
Why Do Banks Handle Payments Like This?
Your lender will typically use this method for paying off your mortgage because it’s more profitable for them. The longer you have a principal amount, the longer they can charge interest on it. The best way for getting around this is to either make extra payments that go directly to the principal or add extra money to your monthly mortgage payment.
How an Interest-Only Loan Works
Interest-only loans are a little more advanced than a standard mortgage. You still have the principal owed with interest-only, but you’re only making payments on the interest. Because of this, your monthly payment is lowered.
Interest-only loans are structured a little differently, too. With a mortgage, you have a 30-year timeline that’s only that single 30-year number. With interest-only, you’ll have the 30-year timeline, along with a note that’s due in 10 years, which must either be paid in full or refinanced.
Why Would Someone Get an Interest-Only Loan?
So what’s the point of only paying interest and never knocking down the principal? Well, the main reason is that with lower payments, you’re able to allocate that “extra” money elsewhere.
Have you heard of the “debt snowball” strategy? If not, it’s where you make minimum payments on all debts except one, the debt that’s closest to being paid off. That one debt then gets all the extra money put into it until it’s paid in full. Then you move onto the next lowest debt, knock that out, and so on.
Interest-only loans can be used like an “investment snowball” strategy. This works best when there are multiple loans at play. By using that extra money which would normally be put towards the principal of multiple mortgages, you’re able to use it to pay off your lowest mortgage and move on quickly.
Things to Keep an Eye Out for Before Getting an Interest-Only Loan
Working with these types of loans can be tricky, so it’s critical that you and your attorney read over the fine print. One thing to keep an eye out for is whether or not your interest rate is variable or fixed.
With a fixed interest rate, you pay the same rate no matter what. Let’s say your fixed rate is 5% for this example. Crazy real estate bubble where demand is high enough that banks can charge whatever they want? You pay 5%. Great Depression-style economic implosion? You pay 5%.
Variable interest rates are tied to the market and can go through crazy highs and lows. That crazy real estate bubble? Expect to pay more than 10%. Great Depression sequel? Maybe your rate is almost nothing.
To be fair, there will typically be a “floor” and “ceiling” to a variable rate. The floor is the lowest amount you can expect to be charged, and the ceiling is the highest. So if the going market rate is 4%, but your floor is 6%, you’re paying 6%. However, if the market rate is 13% and your ceiling is 8%, you’re only on the hook for 8%.
Some investors like variable rates for the gamble that they can pay off the loan before a market fluctuation. I personally am against variable loans for this exact situation. It’s so difficult to budget for a business when you have no clue what you’ll be paying five years from now. When it comes to interest-only loans (or really, any loans for that matter), I’ll only agree to a fixed rate.
A Few More Caveats You Should Consider
In my opinion, interest-only loans are a double-edged sword. Yes, they can be great for real estate investors with multiple loans that need to get knocked out. That said, they can also be giant money pits that can bankrupt your company.
The key is discipline; you’ve got to be responsible with this. I’ve seen folks get these types of loans and use them for things like Disney vacations, which is crazy. The amount of money you’ll pay if you mess this up can take your breath away. Interest-only loans require a laser focus, and if you’re not disciplined with your money, this can be a horrible strategy.
Also, using interest-only loans is a long-term strategy. I wouldn’t expect to see profits until 10-15 years down the road. All extra money should be focused on being used as an investment snowball so that your loans get paid off as quickly as possible.
I’ve seen real estate investors who think they need hundreds of properties for a strategy like this to work. Luckily, it’s not that restrictive; you can do this if you only have a few properties. To me, the ideal number of homes for this strategy to work is around 5-7.
If you’ve got the skills to be disciplined with your finances, using interest-only loans for real estate investing can be a fantastic way to leverage mortgages to your advantage. Make sure you keep an eye out for how the bank will calculate your interest rate, stay laser-focused on your goal, and you’ll be generating profits much faster than you think.
Have you used an interest-only loan strategy for your business? Leave a comment with your tips and let us know how it worked for you.