Interest-Only Loans for Investment Properties

An interest-only loan lets you pay just the interest for a set period, often the first 10 years on a rental loan, so the payment is lower but the balance does not shrink. When that period ends, the payment rises because the full balance must be repaid over the years left on the loan: on a $300,000 loan at 7.5%, a 30-year loan with 10 interest-only years jumps from $1,875 to about $2,417 a month. For 1 to 4 unit rentals, you find interest-only terms on loans outside the standard mortgage rules, such as DSCR loans (approved on the property's rent rather than your income), and on short-term bridge and hard money loans. For 5 or more units, bank and agency apartment loans offer them too.

For the full range of rental loan options, see tips for getting approved for an investment property mortgage.

How an interest-only period works

Each monthly payment equals the balance times the annual rate divided by 12. On $300,000 at 7.5%, that is $300,000 x 0.075 / 12 = $1,875. Nothing goes to principal, so after 10 years you still owe $300,000.

At the end of the interest-only period, the loan converts to principal and interest. The new payment depends on how many years remain:

• 30-year loan with a 10-year interest-only period: the $300,000 is repaid over the last 20 years.
• 40-year loan with a 10-year interest-only period: the $300,000 is repaid over the last 30 years.

Some short-term loans never amortize. The whole balance comes due at maturity as a balloon payment, which you repay by selling or refinancing. Commercial apartment loans can do both: Freddie Mac's small loan has a 5- to 15-year term on an amortization schedule of up to 30 years, so a partial interest-only loan starts principal payments partway through and still leaves a balloon at maturity.

Where investors can get interest-only terms

A standard conventional loan on a 1 to 4 unit rental cannot have an interest-only period. Fannie Mae buys only fully amortizing single-family loans with level monthly payments of principal and interest. Federal qualified mortgage (QM) rules for home loans also bar interest-only periods. On 1 to 4 units, that leaves loans outside those rules, which lenders call non-QM or business-purpose loans. Apartment loans on 5 or more units follow separate multifamily rules, and Freddie Mac's allow interest-only:

LTV, or loan-to-value, is the loan divided by the property's value. Arch Mortgage Funding's DSCR guidelines, as one example, offer 30- and 40-year loans with a 10-year interest-only period. Arch cuts the maximum LTV by 5 percentage points for interest-only, so a purchase that allows 80% LTV amortizing allows 75% with interest-only. It measures the debt service coverage ratio (DSCR), rent divided by the payment, using the interest-only payment plus taxes, insurance, and association dues. A lower payment makes the ratio easier to pass. DSCR loans explained covers the rest of those requirements.

Commercial lenders go the other way. Freddie Mac tests coverage on an amortizing payment even for interest-only loans, and bank regulators expect banks to underwrite an interest-only loan as if it amortized. On a commercial loan, interest-only lowers your payment but does not raise the loan amount, and full-term interest-only can lower it.

The payment math, during and after interest-only

Same loan in all three cases: $300,000 at a 7.5% fixed rate.

What the 10 interest-only years on the 30-year loan do:

• Cash flow: you pay $223 less each month, about $26,700 over 10 years.
• Equity: you owe about $39,600 more at year 10 than with the amortizing loan.
• Interest cost: you pay $225,000 in interest over 10 years instead of about $212,100, about $12,900 more.
• Payment jump: in month 121 the payment rises $542, or 29%. Taxes and insurance come on top of these figures.

The 40-year version has a smaller jump, $223, because the balance is repaid over 30 years instead of 20, but you pay interest for 10 more years.

On an adjustable-rate loan, the reset can raise the rate at the same time principal begins, and the jump is larger. At 8.5%, the 20-year payment on $300,000 would be about $2,603.

Which hold plans interest-only fits

Interest-only tends to fit when:

• You plan to sell or refinance before the interest-only period ends. If you expect to hold 5 to 7 years, the principal you would have paid is small (about $16,100 in the first 5 years on the loan above) and comes back to you at sale anyway, minus the extra interest.
• The property is being renovated or leased up. Bridge and hard money lenders charge interest-only while rents are low, then you refinance into a permanent loan once the property is stabilized. See hard money loans for how those loans are priced.
• You need the DSCR to pass. With $2,600 rent and $550 a month of taxes and insurance, the loan above scores 0.98 amortizing and 1.07 interest-only, which clears a 1.00 minimum, at the cost of a lower maximum LTV.

It is a poor fit when:

• You plan to hold past the interest-only period and the rent may not cover the higher payment. Test the property at the post-conversion payment before you close.
• Your exit depends on a refinance. If rates are higher or the value has not grown when you need to refinance, you may get a smaller loan or none. Our guide to refinancing an investment property covers the tests a new lender applies.
• You are using interest-only to qualify for a bigger loan than an amortizing payment would allow. With no principal paid down, a drop in value leaves you with less equity, or none, when you need to sell or refinance. How financial leverage works in real estate shows how borrowing more affects returns in both directions.

Questions to ask before you choose interest-only

1. How many years is the interest-only period, and over how many years is the balance repaid after it ends?
2. What is the payment in the first month after the interest-only period, including taxes and insurance?
3. Is the rate fixed for the whole loan, or does it adjust when principal payments start?
4. How much does the interest-only option reduce the maximum loan or raise the rate?
5. Is there a prepayment penalty, and does it end before you expect to sell or refinance?