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 risks 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.
About Author
David Luke
David was immediately drawn to the CommLoan mission of creating a better borrower experience when joining the firm in 2015. Initially, David helped grow the lenders on the platform by 6X and worked closely with the software team to improve accuracy and efficiency within the loan fulfillment process. David has underwritten and closed more than $2 billion in transactions ranging from bridge to permanent financing across all major capital sources. He appreciates the wealth creation that real estate has to offer and has been self-managing a small portfolio of single and multifamily properties for the last 10 years. David earned a master’s degree in business from the W.P. Carey School of Business at ASU and will be completing his CCIM Designation in 2021.
RELATED ARTICLES
Insurance for Commercial Property: What’s Covered and What’s Not?
A Guide to Investing in Commercial Distressed Properties
How to Determine the Highest and Best Use of a Property
What is Unlevered Free Cash Flow in Real Estate?
A Comprehensive Guide to Mixed-use Commercial Property
