When does it make sense to pay interest only?

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It is my understanding that the Dodd Frank Act mentioned by Bill Gulley only pertains to homes where the buyer will occupy the home, investment properties do not qualify. Also a seller can provide financing if they are a private individual. Most of these requirements come into play when the seller is a builder selling their own homes and offer financing to buyers. Seller financing from an individual to an investor is pretty straight forward with the terms being whatever works for the both of you. IO loans aren't bad as others have mentioned, you just need to be clear what your investment goals are and use them when they can help you achieve them.

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The only time I've seen it work is if you're a spec builder and you are planning on selling it pretty quickly or you get a good deal and are going to flip it quickly. 10-12 years is too long to do that. You don't want interest only for very long.

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Welcome to BP @Penny Myers !I only use interest only for short term high interest financing when I know I can pay it off quickly and get better long term financing. I hope you aren't thinking of paying interest only for 10-12 years? If you hold a property while paying interest only, you lose the 2-4% (depends how long financed) annually from debt pay down that normally happens. Interest only financing eliminates a factor of equity building, (return on your investment) and that's not good.It concerns me that you mentioned appreciation twice and no matter where you buy, it should always be counted as a potential bonus. Not everybody follows this thinking, but I make my money when I buy. Translation, only buy undervalued properties and you make instant equity by taking ownership of the property.This sounds to me like you are looking for a way to pay at or near full retail and figure out a way to make it cash flow with the interest only financing. Then hope for appreciation to allow you to invest in updating at some point in the future.

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Well @Shawn M. and I'll catch @Steve Babiak too (even though poor Steve is on the ignore list, lol) I'm aware of the superficial matters thought to be understood by investors concerning seller financing by "individuals", those "individuals" are homeowners, often restricted to those living in the subject property and the exemptions usually have other limitations to the number of transactions effected over a period of time, those exemptions vary from state to state in both the number of deals and periods of time. Next, the "individual" who just happens to be in the business of doing transactions may or may not have the same state exemptions as any individual or entity or trust operating in real estate may then be viewed as a dealer, so saying any "individual" can is not correct.Under Dodd-Frank, builders or anyone who performing construction activities on a covered property has special provisions which are even more restrictive. Additionally, I was speaking as to the business of doing transactions by extending financing with a buyer/borrower who is occupying the subject property. Saying "investor properties" are exempt are also incorrect, the Act mentioned cover 1-4 family detached dwellings, to the investor dealer buying the property, that will be a commercial purpose, however when that investor turns around and does a RTO that is no longer an "investment property" the investor has converted the property in that transaction to a residential owner occupied dwelling. Conduit financing is financing that passes funds or equities of one source through another contract to effect other financing. Most installment contracts are structured so that an underlying mortgage becomes the obligation of the buyer. Dodd-Frank specifies that such a buyer may not be given an I/O obligation. Now, Shawn, saying you can do just anything you can dream up in seller financing in commercial transactions is another blunder, have you ever heard of the Uniform Commercial Code, are you aware of predatory lending or predatory dealings under federal or state laws, if you were I can't understand how you can say that anything agreed to is okay. Saying investor to investor does change things a bit more than a loan made by just anyone to an investor or the other way around, the difference is to the sophistication of the parties. The reason commercial transactions are less regulated (not that they are unregulated) is that those dealing in commerce are deemed to be more sophisticated in such dealings. This is pretty much where there is expected to be a level playing field, but that too goes to a point. The issues in financing is that there are areas that are deemed to be so unfavorable, predatory that just because you might think there is a greater understanding doesn't mean there is and there can be violations of acceptable practice that people dealing in real estate have no clue of. Finance is NOT real estate, it is a much more regulated area of business than dealing in dirt and thinking you know finance from knowing something about real estate is naïve.There are accepted, customary methods to do seller financed transactions, proven and acceptable ways to pass through financing to basically assume an underlying mortgage or originate contracts, investors need to stick to them and not get into designing or mixing terms like adding ingredients to a fruit salad. Steve, I think you hit the wrong button on Shawn's post, the new feature available would have been more appropriate. :)

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Penny -Either strategy can work for you, but the underlying problem here is Risk Management.Risk refers to the uncertainty of the cash flows and the assumptions you use in your investment strategy, so as long as you can manage the underlying risks of interest-only loans you should be fine.There are 3 risk factors that I see here: 1) Underlying property values, 2) Risk of interest rates, and 3) Risk of your ability to refinance the properties. Let me address each one individually.Property value risk: Be sure that you are making this assumption (that property values will appreciate) based on data. If your investment model assumes that properties will appreciate and they don't, can you tolerate the loss? Meaning, can you cover your losses and move on to another investment?Risk of interest rates: You mention 10-12 years holding investment. I don't have a crystal ball, but I can assure that interest rates will be different 10-12 years from now. How exactly and how much, and what trajectory they take is unknown. By investing in 10-12 year horizon means that you will have to refinance at least once. If the interest rates increase, will it still be profitable for you?Risk of your ability to refinance: For you to be able to refinance, you need to have assets and income. What if you lose your job prior to refinancing? Would you be able to borrow money some other way? Will property values have appreciated enough for you to sell them and cover the principal?There is no easy answer for your questions (or rules of thumb) since each deal is different and all of the parameters will have an impact on your bottom line profitability and your goal (do you want/need to get positive cash flow every month, or are you looking for a big payoff down the line when you sell). My only advice is to build a simple model in Excel and play with "what-if" scenarios. What if the interest rates go from 3% to 7% during refinancing. What if the property values appreciate at 1% rather than 2%. What if the property values depreciate rather than appreciate.The only time I would take interest-only loans (and still I would be very hesitant since I am a risk-averse type of guy) is when I know for sure I will have the interest fixed. My personal preference would be not to invest in more than 2 years (again a preference being a risk-averse guy). That time frame allows me to eliminate the uncertainty and I have a good idea of what asset prices would be during this short time. For the record, I have never taken an interest-only loan, and I would only do it if I can't get conventional financing, or if there is a special type of situation that would make the deal profitable only with getting an interest-only loan.

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as far as the principal reduction vs increased cash flow discussion:As long as you went interest only and then reinvested all increased cash flow into another investment, I don't really see a problem. Everything is a balancing act though, so proceed with caution. I look at everything as a stand alone investment, but also how it fits into the portfolio as a whole. If you went interest only and the excess cash flow was spent, you are exposed to increased risk in the short and long term. Just know that at the end of that term you have to pay the piper, prepare for that.

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Good comments, know too that under Dodd-Frank, seller financing with interest only is considered predatory lending and isn't allowed as there is no principal reduction. Another issue is that if you are buying and then entering into any installment purchase arrangement, your buyer will not be receiving any principal reduction on the underlying mortgage, consider too that any installment buyer will have the right to make additional payments or a lump sum payment toward amounts owed. So, with this right being in place, once your equity has been paid there will not be any further principal reduction from future payments. Say you bought at 50K, put 10K in it, but 10% down and financed 45K with interest only. You sell at 75K on an installment contract, RTO, CFD, wrap, whatever.Your buyer has the right to make a payment toward that purchase, say they pay 35K, the next payment required must be applied as an additional amount paid to principal that exceeds the interest and this requires a reamortization of that I/O loan with each payment, because it was not amortized. You can have an I/O note in commercial transactions, however if you sell in a residential transaction having your buyer assume that commercial note will be a violation of residential lending requirements, as all amounts financed, directly from equity or through a conduit financing arrangement must be amortized. You can't mix such financing.I/O is fine in a commercial transaction for a short period, even in commercial doing a loan term financing I/O note could still be predatory lending long term, it would depend on other factors as well as to ability to pay and that would not factor in appreciation as it can not be assured. Again, when you get into seller financing, before you dream something up you need to see an attorney familiar with the new financing laws, it's not just in Dodd-Frank but also to emerging predatory dealing and lending laws. :)

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@Penny Myers If I buy a house correctly with seller finance, I always try to just pay interest only for the 5 - 7 years before the balloon payment. It allows me to have better cash flow and since I am flipping it via RTO before the balloon is due, I'll pick up my equity at the end. Doesn't mean that I never do the P & I thing, it's more like whatever works best for be in the manner that I am acquiring. BTW, I never had a home that grew into negative equity although I did have one home that could have been bad for me as the balance came due in 2010. The owner had no problem with extending our relationship for another 5 years as I paid him on time for 84 months. I just sold the home last month and everybody is happy.

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Paying down principal can be a way to force savings. Other than that it is personal preference. Some people don't care about building equity and some do. Having never relied on cash flow my preference is pay-down.Some people even go negative and if things go south give it back.