In the US there is a lot of debate about mortgages and the various options presented to people. The discussion tends to be a bit of a muddle. The poster child for bad loans is sub-prime. Lumped in together are ARMs and the focus of this post, interest-only loans. Throwing the baby and out with the bath water seems to be the order of the day.
Interest-only loans mean that the borrower is effectively renting the money from the bank. Like any renter they need to pay monthly and at the end they need to return to the bank the money provided.
In the UK, lenders recommend interest-only mortgages for all BTL property. As some might already recognize, BTL is the term used in the UK to refer to rental property. Why should investors only use interest-only mortgages? The banks feel that an investor is holding the property to make money. Both from the rental income and the possible capital appreciation in the future. Paying down the loan balance for an asset that is likely to rise seems to trap capital in the property when that cash can be better used elsewhere. Holding the cash in reserve for emergencies and scheduled repairs is a better use. Using the cash to invest further is another. The lenders just do not see the logic in paying down the principal. Loan pay down is not considered the highest and best use for the rental income.
But how will the lender get paid? If you ask them they will say that either the borrower will refinance to extract equity at some point in the future or the loan will be paid off when the property is sold. Only in the case of falling values will the lender be concerned. As the lender expects a 15% deposit (down payment) they do not see much risk of the asset ending up being worth less than the outstanding balance of the loan.
Interest-only loans for real estate are a tool. Somewhat like a car lease. With a house you are more likely to see the asset’s value rise while it is almost a certainty that the car’s value will drop until all you have is rolling scrap. Leases make sense for many car buyers. Interest-only loans are fine for many investors. You just have to understand the math and the assumptions so you can plan for the future. The future might include falling property values in the short run so plan for alternative outcomes.
When the dot.com meltdown happened even good firms that were making money suffered. In the present sub-prime storm all ARMs, all interest-only loans and all other exotic loans are considered toxic. All sub-prime borrowers were somehow taken advantage of by the lenders. It could never be the borrower made a bad decision and now needs to deal with it. Interest-only is a tool. As a real estate investor it is your responsibility to use the right tool for the task. Do Your Own Research (DYOR).
What about the headlines and the other blogs who say…
The savvy real estate investor focuses on the details of the specific deal. They understand their game. They read the headlines to understand what the public is thinking. They know the headlines are largely crap when it comes to finding great deals. They want motivated sellers to present them with great deals. The headlines condition the sellers that the future is bleak. Sellers who only look at the headlines (the sky is falling, house prices are crashing, news at 11:00 PM) will not act rationally. When speaking to a motivated seller the savvy investor needs to know what is possible using the tools in their toolbox. To solve the seller’s problem while picking up the property at the same time. An interest-only loan is one such tool.
You make your profit when you buy. You collect your cash when you sell or refinance.