Considering an interest-only loan for your next commercial mortgage? Do you need some additional information before you can make an educated decision? We’re here to help.
The fact is that there are instances where an interest-only loan can be a great fit for your business or investment needs. In other cases, a fully-amortizing alternative may meet a greater number of needs in the long term.
Let’s take a look at a few of the major pros and cons of interest-only commercial loans. But first, here’s a quick description of how they work.
Interest-Only Commercial Mortgages Defined
An interest-only loan is unique in that the borrower only pays the interest, not the principal, throughout the initial portion of the loan’s term. The specific length of the interest-only period is set within the loan agreement terms.
After this time is up, the loan becomes a fully-amortizing loan, where the borrower makes payments toward both the interest and the principal.
As an example, Commercial Direct, a division of Silver Hill Funding, LLC, offers a 30-year fixed rate loan option that includes an interest-only period of 5 years. If you chose this option, you would make only interest payments for the first 5 years of the loan’s term. Once that period ends, you would pay principal and interest on a 25-year amortization schedule.
Benefits of Interest-Only Loans
The most attractive aspect of an interest-only commercial loan is the freedom and flexibility it provides borrowers at the beginning of their loan’s term.
This means that borrowers can count on having greater financial leverage, which can help fund the beginning phases of a commercial project.
Consider your reasons for taking out a loan in the first place. Are you purchasing a property that needs some aesthetic or structural improvement? You may wish to have more cash available to complete various projects immediately following your purchase.
The owners of startup businesses often choose interest-only loans to increase the amount of cash available to invest in their own growth. During the startup period, borrowers can focus on expansion and productivity while worrying less about paying bills.
Small business owners may also simply want to maximize the amount of cash they have available for as long as possible. Taking out an interest-only loan allows them to generate additional revenue and better position themselves to make the larger loan payments once the interest-only period expires.
Short-Term Loan Strategy
When an investor selects a fully-amortizing loan solution, they’re able to start paying down the principal on the loan and build equity in their commercial property right away.
This is a smart strategy for those who wish to own their property for a long period of time. But investors who plan on owning their commercial real estate for just a few years before selling again may simply wish to keep monthly payments as low as possible. In this instance, building equity is a lesser priority.
Drawbacks of Interest-Only Loans
Interest-only loans make sense for those who wish to keep initial monthly payments low and maximize cash-flow. But other types of borrowers may prefer a fully-amortizing solution.
Here are a few reasons why a prospective borrower may choose not to add an interest-only period to their commercial loan’s term.
Investors and business owners with interest-only loans that include prepayment restrictions are not able to pay down the principal and build equity until the interest-only period ends.
This means years may pass before you’re able to begin building equity and increasing the overall value of your commercial property.
With no equity in their property, borrowers could face a worst-case scenario where property values drop and they eventually owe more than the property is worth.
Perhaps the biggest drawback of an interest-only loan is the shock that comes when the interest-only period expires and a borrower must begin to make principal payments as well.
This transition can be abrupt and damaging for those who are not prepared.
If a borrower was not able to generate sufficient income during the interest-only period of their loan’s term, they may have great difficulty making the much larger payments down the road.
Choosing What’s Right for You
With all the available options out there, finding the right loan solution can be tough. At the end of the day, it’s all about finding the option that meets the greatest number of your needs – both in the long and short terms.
Zack North is the Director of Marketing for Commercial Direct. As a regular contributor to a number of top industry publications, Zack enjoys writing about topics that help investors and business owners approach commercial mortgage financing with confidence.