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How Interest Only Loans Can Create Property Investment Finance Risks

By Kaye Dennan

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Published: 24Feb2010
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The impact of an interest only loan when taking on property investment finance can have a two-fold effect.

Many investors are keen to take out interest only loans and this sounds to be a good strategy at the outset as it means that repayments are lower than if the mortgage was an interest and principal loan. This can be particularly useful when purchasing the property or refinancing to buy another. It is also a property investment strategy that lenders encourage for new investors into the market place because it will often allow them to purchase a property more valuable than they first thought.

But if you choose to take on an interest only loan, do be aware that there are risks involved.

What exactly is an Interest Only Loan?

It is a loan where you are only paying off the interest on the monies that you borrowed for your investment property, with no principal/capital reduction.

Commonly these loans are only set up for a short period of time, say 3 - 5 years, with a refinancing period at the end of that time where a lender may ask for principal to be included in the loan.

An interest only loan could be part of a split loan where interest and principal is paid for 1/2 the loan and the other half is interest only. This giving the investor a small reduction in repayment amounts, but at the same time getting some principal repaid.

Why would you use this real estate investment strategy?

This strategy is often used when an investor wants to purchase a property, but at the same time keep their repayments as low as they can instead of taking a loan for an overly long period of time to reduce a loan repayment. With only the interest payment each time the repayment is quite considerably reduced.

An investor can often purchase a property a little more expensive if the loan is interest only for the first few years. Or if an investor buys a property and the rent is not going to be sufficient to cover the outgoings of the property they may well decide to do interest only so that the short fall is not so great.

How to use an interest only loan to your benefit.

A property investor may have positive cash flow even with an interest and principal loan but may decide to go with an interest only loan because they have sufficient equity to purchase another property and want to keep their repayments as low as possible during the first few years of owning the extra property.

Another reason is that an investor may buy a property that needs repairs so by having lower repayments with an interest only loan the positive cash flow can be used to do the repairs or upgrade the property which will also have the effect of increasing the equity in the property. Then when the investor goes to refinance into an interest and principal loan at a later date the extra property value will help with valuations on the new loan.

Remember, property investment finance is a critical part of your success in building a property portfolio.

Understand the risks in using interest only loans.

Property investment strategies are important and property investors need to understand the risks of interest only loans before they commit themselves into this style of loan when building their property investment portfolio.

Interest only loans seem so attractive with the lower loan repayments but there is a risk so make sure that you understand how it could impact your investment. Here is an example:

- You purchase a property at $210,000 with no down payment because you have equity in other property

- You take out an interest only loan on the new property

- For a while all is going well, then property prices start to slip so instead of owning a property valued at $210,000 it has now slipped to $203,000

What in effect has happened is that the property is now not worth the value of the mortgage, therefore you are going to be asked to pay sufficient monies off the loan to bring it in to a neutral or positive value situation. This is where it gets tricky, because if you cannot do this the bank is going to sell the property because with the interest only loan you have not been paying down the principal as you have been making your repayments.

This is the risk of interest only loans and is a situation to be very aware of if you intend to use interest only loans as a finance strategy.

It is not so bad when you have good equity behind you or a good personal income, but if you are stretching yourself it could put you in a compromising situation and you might have been better to purchase a cheaper property or wait until you have more equity behind you.

Grow your property investment portfolio slowly and surely with property investment finance strategies that are sound and which are written into your investment plan.

Kaye Dennan has been involved in property investing for many years personally and also as a licensed real estate principal. With over 15 years being associated with it herself Kaye is keen to help others with the tips learnt over the years. For more insight into property investing go to Property Investing Know How .

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