Today’s question is about interest-only payments.
As the name implies, when an investor secures a loan with interest-only payments, the monthly debt service is equal to the interest on the principal loan amount. For example, on a $10 million loan at an interest rate of 5% amortized over 30 years, the interest-only payment is $41,666.67. Whereas the debt service on a non-interest-only loan would be $54,486.03 (principal + interest).
The question is: is paying down the principal (i.e., monthly debt service equal to principal plus interest) a more conservative approach than only paying the interest on the principal, especially in the case of a market correction?
“It’s not that it’s more conservative one way or another, however, for an investment, it is usually the preference to get cash back sooner than later. The time value of the additional cash flow received throughout the hold helps increase returns rather than receiving a larger distribution at the sale. Additionally, in the event that there is a catastrophic macro level event where a property loses significant value and [the investor is] unable to pay back the loan when it becomes due, it would be more impactful … to have received the additional cash flow along the way.”
Back to our $10 million loan example – the difference between the interest-only payment and the principal plus interest payment is $12,819.36. Technically, all payments above the interest payment decreases the loan balance. So, rather than receiving that additional payment during the business plan, you will receive it at sale. Due to the time value of money, that $12,819.36 is worth more now than it would be worth in the future (say once the property is sold in 5 years). In the event of a massive reduction in property value, you’ll be happier if you were able to receive those additional cash flow payments, especially if the value of the property is lower than the loan balance that you would have otherwise paid down.
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