How can a real estate investor benefit from interest-only and interest-accruing mortgages?
In this post, we will look into 2 unorthodox types of mortgages that are rarely used but can have some benefits that a real estate investor can use in their favor.
What is the interest-only mortgage? Interest-only mortgage benefits and risks.
The idea behind the interest-only mortgage is quite simple. In the standard mortgage, you borrow money to buy a property with the mindset of repaying this mortgage over the course of the amortization period (10 to 25 years). Thus, each month, you pay the accrued interest on your mortgage plus a tiny portion of the actual loan. As time goes on, you pay off your loan.
With the interest-only mortgage, you borrow money to buy a property. However, for each payment period, you only repay the interest. This means that you don't repay the loan itself, and the amount of principal stays the same. An interest-only mortgage does not have an amortization since there is no repayment of principal.
Let's take a look at how this works. Let's say you took a standard mortgage for $300,000 for a 5-year term with an interest rate of 4% and an amortization period of 25 years. In order to pay off the mortgage in 25 years, with this interest rate, you are required to pay $1,583.51 every month. As you can see, each month, a portion covers the accrued interest for that month. The remaining goes towards the mortgage principal. With time, your interest reduces, and you pay more every month towards your loan.
In the case of the interest-only mortgage, you borrow $300,000. Your interest rate is likely going to be slightly higher given the higher risk for the lender since your principal stays high. In our fictitious case, the lender charges you 5.25%. Each month, your $300,000 loan accumulates an interest of $1,312.5 that you are required to pay. The payment is just that.
Benefits of the interest-only mortgage for a real estate investor
❑ Increased cash flow from the interest-only mortgage
The interest-only mortgage is great for an investor who aims to maximize cash flow and does not care as much about decreasing the loan principal. This mortgage will work best for somebody who wants to use that extra cash to invest in other investments or if the investor buys properties for a short period of time (for example, to fix and flip or otherwise realize a short-term increase in market value). This mortgage may also be beneficial to a borrower who knows that he or she will be receiving an increase in income in the near future. Once that increase is realized, the borrower can switch to a blended payment mortgage.
❑ Increased Purchasing Power from the interest-only mortgage
With an interest-only mortgage, if the investor is prepared to pay the same amount every month as he or she would otherwise pay under the standard mortgage, the investor can borrow more money than otherwise possible. See the following figure for an illustrated example. In the first case, we are paying $1,583 in a regular mortgage to borrow $300,000. In the second case, we borrow the same $300,000 but pay only $1,312 in the interest-only mortgage. In the third case, if we decide to match our monthly payment to the first case, we would be able to borrow $361,945.
If this type of repayment plan is used to purchase an investment property, for example, the investor can deduct the interest paid as a cost of investing. Under this scenario, the investor is able to purchase a property at a higher value than using a blended payment repayment plan while using the income from the property to make the mortgage payments.
Risks of the interest-only mortgage
❑ No Principal Reduction
The fact that there is no principal reduction can put both the lender and the borrower at risk. As such, the lenders usually charge a higher interest rate for this risk. The risk for both the lender and the borrower stems from 2 potential happenings:
The property market value decreases. In case the borrower needs to exit the mortgage, he or she will not have enough money from the sale to cover the principal.
Increase in interest rates. If the interest rates increase, the borrower will have to pay more on a monthly basis. While this would also be true for a standard mortgage, the borrower is at greater risk with an interest-only mortgage.
What is the interest-accruing mortgage? Interest-accruing mortgage benefits and risks.
Interest accruing mortgages are loans that have no repayment of principal or interest during their life. At the end of the mortgage, the entire principal amount is repayable, including all of the accrued interest. Standard forms of Interest Accruing Mortgages tend to be for short periods of time due to the lender’s and borrower's risk. As the following chart illustrates, this type of mortgage accumulates interest at a very fast pace, which is why lenders don’t like these repayment plans to be outstanding for much longer than a year.
Benefits of the interest-accruing mortgage
❑ Cash Flow from the interest-accruing mortgage
Under this repayment plan, there is absolutely no impact on a borrower’s cash flow. In other words, they can simply borrow the funds and forget about the mortgage until the term expires, of course.
Risks of the interest-accruing mortgage
❑ Increasing Debt from the interest-accruing mortgage
Under this repayment plan, the amount borrowed increases over time. The following chart illustrates that increase. Based on this example, the borrower will owe just under $270,000 at the end of 5 years, an increase of nearly $70,000 in debt.
❑ Reduced Equity from the interest-accruing mortgage
Since the debt increases, it eats into the equity that the property has. The borrower must hope that the property appreciates in value over the same period to offset this loss.
In summary, interest-only and interest-accruing mortgages are great for short-term investment when you anticipate selling the property rather quickly (e.g., in a fix and flip investments or other investments when you expect the value of the property to quickly increase). The interest-only option is less risky, and its use can be expanded for longer-term investing. This option is especially beneficial when you receive cash flow from the property and, instead of repaying the mortgage, need to invest it in other investment properties.