Quite commonly property investors get offered ‘interest only loans’ and it all sounds a good idea at the outset but there are factors relating to interest only loans that a property investor needs to be aware of as well when using them as part of their property investment strategies. In actual fact an interest only loan can be, under the right circumstances, a very good way to get your foot in the door when property investing.
What is an Interest Only Loan?
It is a loan where only the interest is expected to be repaid each time with no principal/capital reduction.
Commonly these loans are only set up for a short period of time, say 3 – 5 years.
Such a loan could be part of a split loan where interest and principal is paid for 1/2 the loan and the other half is interest only. Thus some principal is being paid off the equity as well as having reduced repayments.
Why would you take on an interest only loan?
This strategy is often used when an investor wants to purchase a property, but at the same time keep their repayments as low as they can without taking a loan for an overly long period of time which is another strategy for reducing a loan repayment. By only having to pay the interest each repayment the amount is considerably smaller.
If an investor buys a property and the rent is not going to be sufficient to cover the outgoings of the property they may well decide to do interest only so that the short fall is not so great.
Interest only loan where there is positive cash flow.
In a case where the property will have positive cash flow even with an interest and principal loan, an investor may decide to go with an interest only loan because they have sufficient equity to purchase another property and want to keep their repayments as low as possible during the first few years of owning the properties.
Why? An investor may be offered or find an exceptionally well priced property and want to add it to the portfolio but keep the repayments on the portfolio as low as possible in the initial years.
It could well be that the investor is just wanting to keep the repayments low, but there are other possible scenarios too and following is one situation that may be the reason for taking on an interest only loan.
Using lower repayments to upgrade a property.
A property may be purchased that has excellent investment potential but does need a bit of an upgrade in the short term. There could be repairs to the property or properties and by having lower repayments the positive cash flow can be used to do repairs or upgrade the properties. The improvements will most likely have the effect of increasing the equity in the property.
When the investor then goes to refinance at the end of the interest only loan period, the property is that much more valuable because of the repairs and upgrades done with the positive cash flow funds.
Risks of interest only loans.
Property investors need to understand the risks of interest only loans before they commit themselves into this style of loan when building their property investment portfolio.
Interest only loans seem so attractive with the lower loan repayments but there is a risk so make sure that you understand how it could impact your investment.
- You purchase a property at $110,000 with no down payment because you have equity in other property
- You set up an interest only loan
- All is going well then property prices start to slip so instead of owning a property at $110,000 value it is now worth $95,000
What could happen is that with the lower value in the property you are most likely going to be asked by your financier to pay sufficient monies on to the loan to bring it in to a neutral or positive value situation.
If you cannot do this the bank is going to sell the property. This comes about because you have not being paying down the principal as you have been making your repayments.
This is the risk of interest only loans and is a situation to be very aware of when considering this option.
It is not so risky when you have sufficient equity behind you, or cash in the bank, but if you do not it could put an investor in a difficult situation, therefore it could be or have been better to purchase a cheaper more affordable property at the outset.
Build your property portfolio slowly and surely, check out the various property investment finance options available to you and decide whether an interest only loan is for you or if you should choose another altogether, or combine it and have two different types of loans working for you when you set up your property investment finance.
Copyright (c) 2010 Kaye Dennan