Conventional Loan v. Interest Only Loan For Your Income Property Investments

Today we are going to have a little fun with math. I used to hate math. But in my business now, math is my friend. So sit down. This post might be a long one.

As you know, I’m real big on knowing what the outcome of your 4 Benefits of real estate investing will be BEFORE you purchase an income property. And sometimes my clients like me to advise them on different financing options. So today we are going to compare conventional non-owner occupant financing with interest only non-owner occupant financing.
The first note to make here is that when you go with an interest only loan you immediately reduce your 2nd Benefit, Principal Reduction, to zero. So I’m not crazy about that. But is that a bad thing?
First we need some ground rules:
  • $175,000 duplex in play here
  • 20% down payment ($35,000)
  • Financing based on $140,000
  • 6.95% interest, amortized over thirty years
  • 5% appreciation (on average)
  • Rents are $1,500/mo. (not escalating)
  • Expenses are $6,920/yr and include property management, taxes, insurance, a healthy reserve fund and 5% vacancy
Conventional Financing
With the conventional financing for our sample rental duplex the monthly debt service will be $926.73. Or $11,121 per year. Plugging in our numbers from above we know that our formula goes something like:

18,000 GRI
6,920 Expenses
11,080 NOI
11,121 Debt Service
( 41) yr Cash Flow Before Taxes.

So the property is paying for itself. And that’s great! California real estate investors would kill for these numbers. Same is true in Florida and Washington and New York.

At the end of the 6 year holding period we are looking at a investment property that is worth somewhere around $234,500. (Remember our 5% per year average appreciation.) So we should be thinking about an IRC 1031 exchange to re-maximize our leverage.
The Principal Reduction over these 6 years has been $10,317.
So when we measure only the first 2 Benefit we have a gain $10,071.
Interest Only Financing
With interest only financing for our sample duplex the monthly debt service will be $810.83/mo. Or $9,730/yr. Using the exact same formula from above (we’ll start from the NOI) will look something like this:

11,080 NOI
9,723 Debt Service
1,357 Cash Flow Before Taxes

So now this property is generating a fairly substantial monthly cash flow. At the end of the 6 year holding period the house will still be worth the same as our conventional financing house. Let us take the 6 years CFBT and we’ll show $8,142. We cannot add to that any principal reduction so the entire benefit from the first 2 Benefits only is $8,142.

So conventional financing wins, right? I don’t really know. Only you can make the decision of which is better for you. I can tell you this, however.
If you were to take those same monies that you put down for a 80% ltv on your interest only loan and bought two houses with 90% ltv on interest only loans I bet you would find a completely different story.
Now that you know how to do it. Why don’t you work out the numbers and let me know what you found.

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Filed under Financing Options, Real Estate Investing

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