When it comes to real estate investments, there are lots of financing options that you can go for. However, securing the right one is a key part of the investment as it will eventually determine the profitability and eventual success of your venture.
Of the many loan options you can get in financial institutions, one key part of the loan is how much you want to pay and when. Do you want to make equal payments in the lifetime of the loan, or pay a small amount each month and then make a balloon payment?
These two determine whether you’ll go for a fully amortized loan or an interest-only/ partially amortized one. And today, we’ll help you navigate this crucial aspect of financing real estate investments.
What are Interest-Only Loans?
Interest-only loans are a special kind of loan that is, in most cases, preserved for real estate investors. In these types of loans, you are only required to pay the interest of the loan every month, not the principal amount. This means that when you make a payment, you will only be reducing the interest, not the principal.
After a certain period, you can then start making payments for the interest plus principal. And when the loan is due, you are then expected to clear the principal amount in a lump sum. This is what is called a balloon payment. Interest-only loans usually have a short repayment period, mostly five to ten years. However, when the principal amount becomes due, there’s always an option for refinancing.
What are Fully Amortizing Loans?
Fully amortizing loans are the conventional types of loans we are all familiar with. In these types of mortgages, the principal amount is paid at the same time as the interest. The entire amount of the loan, that is, the principal plus interest, is usually divided into equal parts over a long period, such as 30 years.
When you start making payments on a fully amortized loan, you will continue to make the same amount of payment every month. And after the life of the loan, all payments, both principal and interest, will have been made.
Interest-Only Loans: Advantages & Disadvantages
Lower Initial Payments
This is an obvious one as you will not be paying the principal. Due to how the loan is structured, you won’t experience financial strain in the short term, so you can even fund other investments.
Increased Cash Flow Potential
The market can always experience fluctuations. However, an interest-only loan will give you the cash flow you need to cushion yourself, even when the rental income is low.
Interest-only loans provide a high degree of flexibility. This can be very important if you have a fluctuating income source, which will allow you to save during high-income times. An even more suitable plan is if you are building a property that you intend to sell. The proceeds can then be used to cover the principal.
Lump Sum Payment
The obvious disadvantage of these types of loans is that you will have to make huge payments at some point. This can be in the middle of the loan, where you have to adjust from interest-only to interest plus principal, or at the end, where you have to come up with the whole principle in a balloon payment.
Higher Long-Term Costs
These loans involve a higher risk for financial institutions, so they come with higher rates and overall costs in the long term.
Fully Amortizing Loans: Advantages & Disadvantages
Since you will be paying both interest and a portion of the principal, you will be reducing the outstanding balance. This means that your equity will also be accumulating gradually.
At no point will you have to switch to higher payments, so you will be able to plan and budget without issues.
Favorable Interest Rates
These types of loans usually come with more favorable interest rates when compared to interest-only loans. This is especially considering that the loan will cover a longer period.
Higher Initial Payments
Right from the start of the payment, you will have to make high monthly payments compared to interest-only loans. This can impact your short-term cash flow, which can be challenging.
Interest Deduction Reduction
Amortized mortgages can save more on tax in the long term, as you deduct from both interest and principal payments. And as the principal balance decreases over time, the amount of interest eligible for tax deduction also diminishes.
Choosing the Right Loan Type
Since this is a decision that can impact the success of your investment, you should ensure that you evaluate it well. There are several important factors that you can consider to do this. Some of these are whether you are looking for a long-term or short-term investment, your cash flow requirements, the amount of risk you are comfortable with, and your future financial plans.
You can also engage a mortgage professional to help assess your financial situation and discuss your investment goals. This way, you can determine the loan type that aligns best with your needs.