What Is An Interest Only Loan?

June 9, 2021

When purchasing a commercial property, a buyer maybe considering different loan or debt scenarios to acquire the asset. One of the typical scenarios often considered is the interest only (IO) loan. What is an Interest only loan? In an interest only loan, there is zero amortization of the principal. The outstanding balance of the loan remains the same throughout the term of the loan. At the maturity, the entire principal balance of the loan becomes due and must be paid.

For example, you are purchasing a $1,000,000 self-storage facility. You are using an interest only 30-year loan at 4%. The monthly interest payment will be $3,333.33. The final payment on month 360 will be $1,003,333.33 (Interest + Principal Balance). During the entire term of the loan, you will pay $1,200,000 in interest.

Borrowers like the interest only loan because the payment is less than would be owed with an amortized loan, allowing you to keep more of the cashflow and reinvest it into the project or in other projects. For example, if you were to amortize the loan on a constant payment mortgage, the payment would be $4,774 per month. Total payments made for the 30-year term would be $1,718,695.06.  Click the link for an example of these scenarios: Interest vs. Constant Rate

Another advantage to the interest only loan is the entire payment is tax deductible.

The disadvantage to the interest only loan is the large payment that becomes due at the end of the loan term. This can confront the borrower with need to either refinance or sell in order to pay off the debt. If the market has shifted lower, refinancing or selling become a more difficult proposition leaving the owner with the possibility of negative equity.

If you are looking at purchasing a commercial real estate asset, please reach out to CRD Realty. We would be happy to refer you to one of our preferred lenders or commercial loan brokers so you can find the best debt scenario that works with your strategy.

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