Understanding Interest-Only Loans in Commercial Mortgages

For investors considering the purchase of real estate, the goal is to keep costs as low as possible. A component of that is obtaining a low-interest rate, but it may also be important to minimize cash flow loss. An interest-only loan may offer some assistance in that area.

What is an Interest-Only Loan?

In its simplest terms, An interest-only commercial mortgage is a loan in which the borrower/ investor pays just interest on the borrowed funds for the first set of years. This is typically 10 years but may be less. This is unlike a traditional commercial loan in which the borrower pays both interest and principal with each payment. In other words, the debt service on the commercial mortgage loan is equal to the interest on the loan’s principal.

In many situations, this can save the borrower money. For example, if the commercial investor obtains a 30-year loan for $10 million with a five-year interest rate, they will pay an estimated $41,667 in interest. By comparison, in a traditional loan, this would include $54,486 in payment, which includes the borrowed funds and the interest applicable on the loan.

How Interest-Only Loans Work in Commercial Mortgages?

An interest-only commercial mortgage requires payments like traditional loans, but the loan payment is solely the interest on the loan rather than any principal. That means that, with each payment, the borrower is not paying down the borrowed funds but just paying a fee for borrowing the funds.

In this scenario, the borrower will benefit from a lower monthly payment. That means the borrower can conserve more of their capital for other needs during the interest-only period. They can use those funds for other needs.

This type of loan is very common with construction loans. When the property is fully built, the interest-only loan is refinanced into a traditional commercial loan requiring principal and monthly interest payments. This type of loan structure is also very common with bridge loans, or short-term loans an investor may take on for a period of time until they flip the property or secure a lower interest rate.

How to Calculate Interest-Only Loans Payments

Borrowers can use various online calculators and tools to determine their exact interest-only payments. However, the payment formula is very simplistic.

To calculate the interest payments on these loans, simply multiply the loan balance (the borrowed amount) by the annual interest rate. Then, divide this figure by 12, or the number of payments for the year.

In this type of loan, the borrowed funds do not drop, which means the interest payments remain the same throughout the life of the loan until it is refinanced or until a balloon payment for the borrowed amount is due.

Why Borrowers Opt for Interest-Only Loans?

There are numerous scenarios in which the borrower may wish to pursue an interest-only mortgage rather than a traditional conventional loan.

One key opportunity occurs when the goal is to acquire the property, make repairs to upgrade the value, and then refinance the property at a higher level and, often, a lower interest rate. This method can work well for those who plan to acquire and refinance properties with higher cap rates.

Another option is to use it for ground-up development. For those who are building a property, this type of loan can be ideal because it lowers the overall cash flow demand on a property that may not be generating any funds for the company itself.

For those who plan to buy, repair, and flip, this can also be beneficial. It keeps a higher cash flow during the repair and upgrade phase and allows for a fast sale in the right market conditions.

Benefits and Risks of Commercial Interest-Only Loans

As a borrower, there are several notable reasons to invest in an interest-only mortgage compared to a traditional commercial mortgage loan. These loans present opportunities and drawbacks for borrowers. They may not always be available as well.

For many reasons, borrowers may not qualify for these loans because of the higher risk associated with lending them. Higher qualifications, then, may be a factor.

Potential Benefits

There are several core benefits potentially present with interest-only loans for investors.

For the borrower, there are lower risks with an interest-only loan. They are not putting any capital into the payment of the loan but rather paying more of a fee for borrowing the funds. This means that if the property’s value falls significantly, and they are underwater in a traditional loan, the borrower is less at risk. The lender, though, is at a higher risk.

Another benefit to these loans is that they offer a better level of cash flow. Each payment requires less to be paid out, leaving more in the budget for other needs, including things like renovations and upgrades. For investors who want a lower monthly payment on a higher risk property, this type of loan structure may make that possible. It works to increase the net operating income for the property as a result.

Potential Drawbacks

There are some drawbacks to these loans, though. The first is that the principal is not being paid down. That means that it will be necessary to make a balloon payment or refinance the loan at some point when the loan is due.

In addition to this, when the interest-only period expires, many of these loans will have a debt service increase. This could impact the bottom line and cash flow of the business, especially one that may not have the cash flow for doing so.

Interest-Only Loans vs Conventional Loans

Borrowers should take the time to consider both types of debts to determine which offers the best long-term and short-term benefits for the investment decision.

The biggest initial difference in these loans is that a conventional loan will require a monthly repayment that is higher because it factors in the principal portion of the loan repayment. Additionally, these loans also will eventually lead to the debt being repaid. With an interest-only loan, that is not the case during the interest-only period.

The higher cash flow is certainly a significant advantage here, but there are other factors that make it a higher risk for the borrower. With a conventional loan, the property is building equity over time with each payment. This may help to reduce some risk and aid in reducing the overall cost of borrowing if needed.

The costs can also vary significantly. Because of the higher risk to the lender with these loans, it may lead to a higher interest rate charge, especially for unproven investors. This makes the loan more expensive and impacts the overall profit margin for the investment.

Wrapping Up

An interest-only commercial mortgage loan presents key benefits to borrowers, especially enabling a borrower to lower the demand on their cash flow for an initial, and sometimes long, period of time. For many borrowers, this can open the door to more borrowing power, though it increases the risks in some scenarios. This can make it more costly in the long term if the property owner holds onto the loan long term.