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- What Are Netting Escrows & How Does It Work?: The Best Guide - January 2, 2024
- The Secret About Prescriptive Easement: Top Guide 1 Must Know - December 4, 2023
- About Home Equity Loans In Texas And How Can One Obtain It - November 27, 2023
Interest-Only Mortgage Affect Real Estate Investment
If you have been in commercial real estate for a while, you have probably heard of an interest-only loan. An interest-only home loan in commercial real estate is exactly what it sounds like.
It is a period during the loan term where you are only going to be responsible as the borrower for interest payments rather than interest and principal payments on the loan.
At face value, that might sound like a good deal and no brainer to get an interest-only mortgage, however, in this post, we will break down how an interest-only mortgage is going to affect your key returns on a real estate deal.
There are three big effects that an interest-only mortgage would have on your returns metrics versus an amortized loan.
3 Major Effects Of Interest-Only Home Loan on Your Returns
1) Increase Cash Flow and Cash-on-cash return
The first and the most obvious is that the interest-only home loan is going to increase your cash flow and your cash on cash return.
It is pretty clear that your cash flow is going to increase if you don’t have to pay principal payments for that month.
When you look at it from cash on cash perspective, meaning that the cash flow that you receive as a percentage of your equity invested up to that point, that is when you start seeing even bigger differences, especially for the investors looking for a high yield on their deals.
For an investor base that is very focused on cash flow yield, adding an interest-only period into your loan can increase your cash on cash returns significantly and take that value from three or four percent to maybe seven or eight percent.
2) Decrease Overall Profits On Deal
Even with higher cash flow on the deal, a downside of an interest-only mortgage is that it is going to decrease your profits on the deal assuming that everything else is equal.
The reason why this happens is that you are not paying down your principal balance every single month and therefore, you are paying higher interest payment every month than you would be if you were paying down that loan with principal and interest deduction.
This usually is not a huge dollar amount but it is something to be aware of if you are not focused on cash-on-cash.
3) Increase your Internal Rate Of Return (IRR)
As far as the internal rate of return or IRR goes, the third thing that an interest-only mortgage would do for otherwise identical cash flows is to increase your internal rate of return.
You may be asking how that happens even when you have lower profits on the interest-only deal. The reason is that the IRR is a time value of money calculation.
Meaning that the cash flow that you receive earlier on in the whole period is worth more than the cash flow that you receive later on in the whole period.
Even though your total profit will go down, you will receive much higher cash flows earlier on in the whole period which will boost that internal rate of return.
So if you and your investors care about cash flows upfront and want to be able to re-invest that cash flow early on in the whole period, only the interest-only mortgage will allow you to do that.
Conclusion
At the end of the day, what can you take away? If you are looking for cash flow and your investors are looking for cash-on-cash returns, the interest-only mortgage period is going to be your best bet.
This can also be a huge help when you are undergoing a renovation at a property and you are expecting some lower occupancy rates and maybe lower rental rates over the next 12 to 24 months.
With all of that said, you may want to be cautious about an interest-only home loan, if you are just planning to buy and hold the property for a long term and focused on wealth accumulation, getting an interest-only mortgage loan may not be advisable.
