Interest-only long-term financing: Does it make sense to you?

Question

I've been approached by an Albuquerque investor who is willing to offer interest-only financing for long-term, buy-and-hold, projects in New Mexico and surrounding states. What is your opinion of it? Would it make sense for any of your deals? I'm not sure it would help me if I'm comparing it to 4.25%, 25-year bank financing that I've been quoted recently for an apartment building. But it has some other attractive features:

Details:

Minimum loan: $100,000; Maximum loan: $2M
Maximum LTV: 80% of purchase price (seller can carry 2nd position for up to 20%, so zero-down loan is possible)
2+ unit or commercial properties only; no owner-occupied
4% interest-only for 12 mos., followed by 8% interest-only for up to 9 additional years.
2% origination fee
3% pre-payment penalty if paid off in years 0-5; no prepayment penalty in years 6-10.

When I do the math, the required monthly payment at 8% interest-only is about the same as 5.25% financing amortized for 20 years...sort of a typical local bank rate for commercial property. Of course, during Year 1, the monthly payment would be half that, and that is pretty much unbeatable. The zero-down option and low origination fee are also attractive.

Feedback?

Marc C. · Answer

Hey, thanks for the modeling, Ted! You convinced me. I guess it's just awfully hard for private money to compete with 4.25% money available from the banks. If it didn't have that prepayment penalty, you could just pay as much principal with each interest payment as you wanted...a lot when you're cash rich, none when you are cash poor. That flexibility would be nice. But the 8% still is just wasted money.

Ted Wilcox · Answer

I modeled this simply. The numbers are as follows:Principal: $2,000,000Interest Rate: 4.25% for Principal and Interest payments4% for 1 year, 8% for 9 years for Interest OnlyLoan Term: 30 Years paid monthly.Interest Only total payments: $1,520,000Principal and Interest payments: $1,180,655.74Difference in payments: $339,344.26Principal Paid in first 10 years: $411,135.31So assuming the property was worth 2,500,000 at the end of 10 years, and assuming the cash on cash return was the same, the return at the end of year 10 would be:Interest Only: $500,000 Principal and Interest: $911,135.31 plus the difference in payments of $339,344.26 or $1,250,479.57. Of course you paid yourself the principal, in theory so if we subtract that you would get $839,344.26 as the return on the investment, plus you would have the $411,135 principal in your pocket too.The bottom line is that paying down the principal reduces the amount of interest you are paying over the life of the investment, so it also helps increase the return at the end. And that 8% interest is really bad. There is probably a point where interest only over 10 years would be helpful, but you would have to model it carefully.If the interest only rate was 6% it still isn't great. By making principal payments you would net $479,344.26 after return of principal vs $500,000.00. You would have earned $20,655.74 more with the interest only, but you wouldn't have $411,135.31 principal in your pocket. Cash in hand would be about $390,000 less at the end.

Steve Vaughan · Answer

I don't do short-term financing on long-term assets in general. Is your goal to put long-term, amortizing financing on it in a year or so through a refi @Marc C.? That may work and would be the only way I would do it. How many countless 'investors' (homeowners using their homes as ATMs, too) were caught with their pants down when loans reset during the GRC? Let's not allow our memories to be so short!

Ted Wilcox · Answer

I have been modeling interest only for the property we are buying. Of course it reduces the debt service at the beginning, but you still have to pay the principle at some point. In my model I only use 1 year of interest only, but it decreases the ultimate return by a relatively large percentage. From a purely financial standpoint it makes some sense because you are not putting any more funds into the investment and are able to put those funds into upgrades or new investments. I don't like the 8% interest only at all. I think the 4.25% loan would be a much better deal even if you are paying down principle. It would be interesting to model that over time. Of course it would also depend on your end state for this investment. Is this buy and hold or are you selling it after 5 years? The max amount of the loan is also an issue for me. Maybe we should look at this at the next Albuquerque Investment Mastery Meetup group.