There are several financing options available for commercial real estate investors — including multifamily players — and each loan can serve a different purpose and business strategy. One option is an interest-only loan. As the name suggests, the key aspect of an interest-only loan is that investors are only required to pay the interest on the loan for a specified period. This can be an attractive financing option because it frees up cash for other investments or expenses. However, there are also risks associated with interest-only loans that you should be aware of when you shop around for loans and before you decide what’s right for you. 

SEE ALSO: What You Need to Know Before Applying for a Commercial Real Estate Loan

Interest-Only Commercial Loan Basics and When to Get One 

To reiterate, an interest-only loan is a type of financing where the borrower only pays the interest on the loan for a set period of time. At the end of the interest-only period, the borrower needs to start paying off both the principal and interest.

Acquisition & Refinance

First, interest-only loans can be used to acquire or refinance properties with higher cap rates because they allow borrowers to maximize their leverage while minimizing their cash outlay in the short term. At the same time, this type of loan is also useful for investors buying distressed properties with high levels of vacancy, as well as for investors with a quick exit strategy. 

Ground-up Development

However, interest-only loans are even more popular for investors constructing a property, as they need to save as much money as possible during the development period. This is essential because there’s no stable cash flow during the construction phase, and paying only the interest on the loan can help borrowers reduce expenses until the property is stabilized and producing income.

Value-Add & Major Repositioning 

Borrowers with value-add projects or substantial renovation plans can also benefit from interest-only loans. During major capital improvements, a property typically produces only a fraction of its income. A loan with interest-only payments can help borrowers save money in the short term until the property upgrades are completed and occupancy recovers.

Benefits of Interest-Only Loans 

The greatest benefit of an interest-only loan is that it conserves cash flow in the short term. This can be helpful if you are looking to reinvest that cash into other property acquisitions or improvements.

Additionally, because you are only paying the interest on the loan, your monthly payments will be lower than if you were paying both principal and interest. This can free up additional cash flow each month. 

Risks Associated With Interest-Only Loans 

Of course, there are also risks associated with interest-only loans that you should be aware of before deciding if this type of loan is right for your situation. One major risk is that your monthly payments could increase significantly at the end of the interest-only period when you are required to start paying both principal and interest. 

Additionally, if your property’s value decreases, you could find yourself underwater on your loan — owing more than the property is worth. Before taking out an interest-only loan, be sure to speak with a qualified commercial real estate broker to discuss all of the risks and benefits associated with this type of financing. 

Popular Loan Types with Interest-Only Payment Options

Many lenders offer interest-only loans, or loans with at least some period of interest-only payments. These include banks, insurance companies, and CMBS lenders. Additionally, agency and government-backed loans, such as HUD, Fannie Mae, or Freddie Mac, have some loan products with interest-only components. 

Primarily, most construction loans have an interest-only period, designed specifically for the duration of the construction of any multifamily or commercial property. Bridge loans and mezzanine loans also carry interest-only payment options.

Some specific agency products with interest-only payments include Freddie Mac Fixed-Rate Conventional Loans, Freddie Mac Senior Housing Loans, and Fannie Mae Reduced Occupancy Affordable Rehab Loans.

How Do Interest-Only Loans Compare to Traditional Amortizing Loans? 

A traditional amortizing loan is one in which you make regular payments toward the principal balance of the loan, with a portion of each payment going toward interest. The longer the term of the loan, the more time you will have to repay the principal balance. Traditional amortizing loans typically have terms of 15 or 30 years, though some — like HUD’s 221(d)(4) construction loan — may amortize over 40 years.

One of the main benefits of a traditional amortizing loan is that your monthly payments will remain consistent throughout the life of the loan. This can make budgeting and cash flow planning much easier.

Another benefit is that, because you're paying down the principal balance over time, you'll eventually build up equity in the property. This can be beneficial when you refinance or sell the property. 

The downside of traditional amortizing loans is that they may require a large down payment (typically 20-30% of the purchase price). Additionally, if you sell the property before the loan is paid off, you may have to pay a prepayment penalty to retire any debt.

Final Thoughts 

When choosing between a traditional amortizing loan and an interest-only commercial loan, it is important to consider your unique situation and needs. If you are looking for predictability and stability, a traditional amortizing loan may be the better option for you. However, if you need flexibility in your budget or expect rent increases during the life of the loan, an interest-only loan could make more sense. 

As with any major financial decision, it is important to speak with a professional before making a final decision. At Multifamily Loans, our advisors can walk you through your options and connect you with the best lenders to get you the most suitable loan at the best terms. Fill out the form below and we’ll get in touch with you.