were a thing. Borrowers could even get interest-only loans for commercial property acquisitions. A lot has changed since then. Today’s interest-only loans can be good or bad depending on circumstances.
It is still possible to get interest-only loans on both residential and commercial properties. But thanks to the 2007-2008 housing crash and subsequent banking reform, they are much harder to come by. Residential borrowers need stellar credit and the right bank to get an interest-only loan. In the commercial sector, the loans are mostly the domain of private lenders.
Hard Money and Bridge Loans
Interest-only loans for commercial real estate often take the form of either hard money or bridge loans. Though there are some distinct differences between the two types of funding, for the purpose of talking about how interest-only loans work, they are nearly identical.
Actium Lending, a Utah hard money firm based in Salt Lake City, explains that the majority of all hard money and bridge loans are designated for real estate investments. An Actium client may be after a hard money loan to purchase an office building with a high rental yield. A competitor’s client may be looking for bridge loans to fuel a fix-and-flip investment strategy. Both types of loans are likely to be structured as interest-only loans.
The Interest-Only Principle
The interest-only principle is pretty simple to understand. Imagine a hard money loan with a 24-month term. The first 23 installments cover just the interest. The final installment, due on the loan’s maturity, covers the final interest payment and the original amount borrowed. The interest-only structure is identical for a bridge loan, despite bridge loans having much shorter terms.
Incidentally, interest-only residential mortgages work the same way. That’s why they were so attractive back in the McMansion days. Tons of people who could not truly afford to buy a new home did so via an interest-only mortgage. The easy availability of interest-only mortgages led directly to the housing crash. But that is another topic for a different post.
Why Property Investors Love Them
Interest-only loans are sometimes referred to as ‘balloon mortgages’ thanks to the large sum due at loan maturity. For me personally, the pressure to come up with the entire principle in one fell swoop is too much. And yet real estate investors love interest-only loans. Why?
Actium Lending explains that hard money loans are short term loans by nature. Terms rarely exceed 24 months. Borrowers know this. They know they will have to cover their loans through traditional financing, selling an asset, or generating revenue from the acquired property. It is all in the plan. What’s more, they are prepared for it.
The advantage of an interest-only loan is the lower installments. Lower installments free up cash an investor can put elsewhere. Maybe the cash can be put into buying a second property. Perhaps it can be put into renovating the property just purchased. Either way, the big draw is spending less cash on monthly installments with the understanding that there is a plan in place to make that final balloon payment.
Use Them With Caution
If I were giving advice to new real estate investors, I would tell them to use interest-only loans with caution. The right strategy and a good exit plan minimizes risk. On the other hand, obtaining interest-only loans recklessly could lead to significant losses. The last housing crash is a clear example of what could happen when interest-only loans are written indiscriminately.
