Christopher Miller, MBA | Specialized Wealth Management
Originally Appeared in Apartment Management Magazine
Happy New Year! As a real estate investor, you have probably heard of interest only loans. If you haven’t, these loans are exactly what their name implies; a loan where the borrower makes payments of “interest only.”
Most loans, like an auto loan or a traditional home mortgage, are “amortizing loans.” This means that each payment you make will include both an amount that decreases your principal (the loan balance) and an amount that is simply an interest “fee.” This interest charge is what you are paying to “rent” the money.
For example: if you buy an investment property with a $1,000,000 loan, fully amortizing over its 30 year term, at 4%: your monthly payment will be $4,774. During the first year of your mortgage, your payments will total $52,289. As I mentioned earlier; these payments have separate components that represent principal and interest. $17,610 will go to pay down the principal balance of the loan, and you will be charged $39,679 interest to “rent” the money. Change that loan to an interest-only one, and your monthly mortgage payment will drop to $3,333 or $40,000 annually. Could you use an extra $1,441 / mo. of cash flow?
Aren’t Interest-Only Loans Riskier?
Some in the real estate industry, (often those trying to sell conventional amortizing loans), will dismiss interest-only loans as “risky.” I think a substantial case can be made to support a statement that “interest-only loans can offer less risk than an amortizing one.” How could this be? Let’s use the example above and compare an amortizing loan at $4,774 per month vs. an interest-only one at $3,333 monthly. Which payment will be easier to make every month? When taking out a mortgage, your primary risk is that you won’t be able to make the monthly payment and will lose the property to foreclosure. With which of the above loans is that most likely to happen? The loan with the higher monthly payment is always the harder one to pay.
Amortizing Loans Are Less Tax Efficient
Most everyone knows that mortgage interest, just like insurance and property taxes, is tax deductible for your rental properties. Some don’t realize that the portion of their payment that goes towards amortizing the loan is taxed as income by the IRS. Even though it is not spendable income, as you’ve already spent it on something else, you are still taxed on it. As I often say; a tax on money that is already
spent is the most expensive of taxes. For a high earner in the 45% (Federal + State) tax bracket, this leads to an additional annual expense of $7,925 when we use the $1,000,000 amortizing loan above. Note that, with an interest-only loan, you would still pay this $7,925: you would just have $9,686 left after taxes to show for it. With the amortizing loan you have already spent this money on amortization payments. By offering more spendable income, the interest-only loan is starting to look more attractive. Additionally, due to the way an amortizing loan works, the taxable portion of your monthly payment will get larger every month. We’ll explore that in the next paragraph.
How Does an Amortizing Loan Work?
As a loan amortizes (as the balance is paid down over time), the principal of your loan decreases. Therefore, your interest charge will decrease with the loan balance. (4% of a lower principal amount yields a lower interest charge.) Because your monthly payment remains the same; the amount of expenditure that goes towards the mortgage balance will decrease every single month. Your first monthly charge on the $1 million loan will include $3,333 interest + $1,441 principal = $4,774. Your last bill is $16 of interest and $4,758 principal = $4,774. Although your monthly expense has stayed the same, your principal payment, (and your tax bill), have both risen steadily over the loan term.
But I Am Losing Out on Paying the Loan Down – Right?
Well, I would not call it “losing” anything. Rather than giving that income to the bank to pay down your balance, you are keeping that money for yourself. An amortization payment isn’t really an “expense” like electricity, where the money is gone forever, but it does represent less money that you can spend today. Would you rather have a dollar today or a dollar in the future, when your loan is paid off? Myself, I think that I could make better use of a dollar today, and would rather have it than give it to the bank.
Note, too, that this “paying down” of your mortgage is not significant in the first 10 years of your mortgage. By again turning to the $1 million amortizing loan above, we can calculate our yearend loan balances by year. After 4 years, the loan balance is still $925,136, it is $882,973 in six years and only crosses the 20% paid threshold in year 10 when it ends the year at $787,840. Your year 10 loan balance with an interest-only loan would still be $1,000,000, but you haven’t “lost out” on $212,160 by any stretch. In fact: that $212,160 went directly into your pocket rather than the bank’s. This would produce almost a quarter million dollars more spending money over a decade. Now THAT is attention getting.
Are Interest Only Loans for You?
The point of my article this month isn’t to convince my readers to run out and get interest only loans. I’m only seeking to educate investors about these financing vehicles. Too often I hear investors dismiss ideas offhand without learning more about them and thinking critically regarding their use. After all, informed landlords are smarter investors: and smarter property owners have the opportunity to be more successful. If you’d like to talk about this month’s topic, my toll-free number is (877) 313-1868.