Interest-Only vs. Interest-As-Drawn Loans for Real Estate Investors
Are you on the hunt for a new property to add to your portfolio? Or maybe you're in the process of refinancing an existing loan? Either way, it's important to understand the ins and outs of different loan repayment structures, especially when it comes to interest-only and interest-as-drawn real estate loans.
These two types of loans might sound like dry financial jargon, but trust me, they can have a huge impact on your bottom line. The repayment structure you choose can affect not only your monthly payment amount but also the total cost of your loan once the interest-only period ends.
So, let's roll up our sleeves, dive into the nitty-gritty of interest-only and interest-as-drawn loans, and discover how they can impact our real estate investment strategy.
What’s the difference between interest-only and interest-as-drawn real estate loans?
Let's break down the difference between interest-only and interest-as-drawn loans in plain English. The main thing that sets these two repayment structures apart is when you're paying the interest.
With an interest-only loan, you only pay the interest for a certain amount of time, usually around 5-10 years, before you start chipping away at the principal. So during that initial period, your monthly payments are lower since you're not paying down the actual loan amount yet.
On the other hand, with an interest-as-drawn loan, the interest payments increase as you draw down more of the loan. Basically, the more you borrow, the more interest you pay each month.
Understanding an interest-only loan
Let's talk about interest-only loans and what they mean for your monthly payments. When you sign an interest-only loan, it’s structured so that you only pay the interest portion of the loan for a certain amount of time, usually around 5-10 years.. During this time, your payments are lower because you're not paying off any principal.
Once the interest-only period ends, you’ll begin making payments on both the principal and interest, which can result in higher payments.
Benefits of an interest-only real estate loan
Interest-only real estate loans can have several benefits when you’re using them in your investment portfolio. Let's look at a few.
Lower loan payments early
Since you only pay interest during the interest-only period, the monthly payments are usually lower initially than with a standard real estate loan.
This is ideal if you’re a real estate investor who wants to keep your initial costs and expenses low until the property starts generating income through rentals or after the sale of a fix-and-flip property.
Interest-only loans can be more flexible than traditional real estate loans. Depending on the specific terms of the loan, you may be able to make additional payments towards the principal during the interest-only period without incurring a prepayment penalty. This early payment schedule can help minimize the overall cost of the loan.
Cash flow management
Real estate investors are always looking for ways to maximize their cash flow, and interest-only loans can be a great tool to help them do just that. Since the monthly payments are lower in the beginning, this can free up some additional cash flow that you can use to invest in things like renovations, development, or even acquiring a new property altogether.
Possible tax advantages
Sometimes, the interest on an interest-only real estate loan may be tax-deductible and reduce your overall tax liability. That’s why we recommend that you consult with your own team of tax, legal, and accounting advisors before engaging in any real estate transaction.
Basics of an interest-as-drawn real estate loan
With an interest-as-drawn loan, you’re only required to pay interest on the loan amount that has been disbursed or “drawn down” to date. The interest payments increase as you draw down more of the loan.
This payment structure can be especially helpful if you only need to access a portion of the loan funds at a time or if you're focused on reducing interest costs in the short term.
Benefits of an interest-as-drawn real estate loan
If you're a real estate investor who wants to maximize cash flow and minimize out-of-pocket expenses, an interest-as-drawn real estate loan (also known as an interest reserve loan) could be a good option to consider. Instead of making monthly interest payments out of your own pocket, the interest payments are drawn from a reserve account that's set up as part of the loan structure.
This means that you don't have to worry about coming up with the cash to cover your interest payments every month, which can be a big help when you're starting out and looking to keep costs down. Let's break down some of the potential benefits of interest-as-drawn loans.
Lower initial payments
Like interest-only loans, interest-as-drawn loans can have lower initial monthly payments since the borrower isn’t required to pay the interest payments out of pocket or “pay down” the principal. This strategy can free up and increase cash flow for renovations and construction or to purchase additional properties.
With an interest-as-drawn loan, you don't have to worry about making regular interest payments out of your own pocket. Instead, the interest payments are drawn from a reserve account that's set up as part of the loan structure.
Simplified planning and budgeting
With an interest-as-drawn loan, you'll have a clearer picture of your available cash flow from month to month. And because the interest payments are covered by the reserve account, you can plan your budget more effectively and make more informed decisions about how to allocate your resources. This can make budgeting and financial planning more predictable and stable.
If you’re a real estate investor working on construction and renovation projects, interest-as-drawn loans can help cover the costs if the project exceeds an original budget.
Keep in mind...If you’re considering an interest-as-drawn loan, there are a few considerations to keep in mind. The interest reserve account may have a limit, which can be an issue if the project takes longer than expected or goes over budget. With an interest-only loan, consider that the overall cost of the loan may also be higher since the initial payments only cover the interest, not the principal, during the interest-only period.
What type of real estate loan payment structure should you choose?
As a real estate investor, you know that every project is unique, with its own set of financing needs and requirements. That's why it's so important to carefully evaluate your options when it comes to interest-only and interest-as-drawn loans.
While both types of loans can offer certain advantages, they may not be the best fit for every project. That's why taking a project-by-project approach is crucial when evaluating your financing needs.
By carefully considering the specific requirements of each development phase, you can choose a financing option that aligns with your goals and objectives. Whether you're looking to minimize interest costs in the short term, increase cash flow, or simply gain greater visibility into your available cash flow, a variety of financing options are available to meet your needs.
Ultimately, the key is to work with a trusted lender who can help you navigate the various financing options and choose the one that's right for your specific project. With the right approach and the right lender by your side, you can maximize the potential of your real estate investments and achieve the financial success you're looking for.