An interest-only loan is the one place in a rental deal where you can raise the cash flow without touching the rent or the price. The cost is not hidden, but it arrives on a date years away.
How does an interest-only loan work?
You pay the lender its interest and nothing toward the balance.
The CFPB describes an interest-only mortgage as one with “scheduled payments that require you to pay only the interest for a specified amount of time”, and is blunt about what that means for the balance: “The amount that you owe on the loan does not go down with each payment” (What is an interest-only loan?).
That makes the payment easy to work out. It is the balance times the rate, divided by twelve, and it does not change while the period runs.
Take the rental calculator’s example house: $250,000 renting for $2,750 a month, bought with 20% down on a 30-year loan at 7%, with a 5% vacancy rate, $3,000 of property tax, a $1,400 policy, 5% of rent each for maintenance and the CapEx reserve, and 8% for property management. The $200,000 loan costs $1,331 a month when it amortizes over 30 years. Interest only on the same balance is $200,000 times 7%, divided by twelve: $1,167.
What does interest only do to the cash flow?
It adds the whole $164 difference, because nothing else about the house changes.
| 30-year loan | 10 years interest only | |
|---|---|---|
| Rent, after 5% vacancy | $2,613 | $2,613 |
| Property tax | −$250 | −$250 |
| Insurance | −$117 | −$117 |
| Maintenance (5%) | −$137 | −$137 |
| CapEx reserve (5%) | −$138 | −$138 |
| Property management (8%) | −$220 | −$220 |
| Loan payment | −$1,331 | −$1,167 |
| Cash flow each month | +$420 | +$584 |
These are example figures, not a forecast for any market. The line-by-line build of the left column is in rental property cash flow.
On the calculator’s own measures, the Cash-on-cash return on the same $57,500 of cash goes from 8.8% to 12.2%, and Debt coverage (DSCR) goes from 1.32 to 1.50. The house did not get better. The loan asked for less.
What happens when the interest-only period ends?
The balance you never touched comes due on a shorter clock.
The CFPB lists three ways out: “Paying off the loan balance all at once”, “Refinancing the mortgage loan, if refinancing is available”, or “Beginning to pay off the balance in monthly payments, which are higher than the interest-only payments”. It also warns against counting on the first two: “Don’t assume you’ll be able to sell your home or refinance your loan if your payment increases.”
Take the third route here. Ten years of interest only leave the full $200,000 to clear in the 20 years the loan has left. Set Loan term to 20 years in the calculator and the payment is $1,551, which is $384 more than the interest-only payment and a third higher. Cash flow falls to $200 a month, the Cash-on-cash return to 4.2%, and Debt coverage (DSCR) to 1.13, close enough to 1.00 that a vacancy or a tax reassessment pushes it under.
What did the ten years cost?
Exactly what you kept, plus the interest on the balance you kept owing.
| 30-year loan | 10 years interest only | |
|---|---|---|
| Payment, years 1 to 10 | $1,331 | $1,167 |
| Cash flow, year 1 | $420 | $584 |
| Cash-on-cash return, year 1 | 8.8% | 12.2% |
| Debt coverage (DSCR), year 1 | 1.32 | 1.50 |
| Paid toward the balance in ten years | $28,375 | $0 |
| Interest paid in ten years | $131,297 | $140,000 |
| Owed after ten years | $171,625 | $200,000 |
| Payment, year 11 on | $1,331 | $1,551 |
The extra $164 a month over 120 months is $19,673 of cash you held instead of the lender. The amortizing loan put $28,375 against the balance in the same decade. The $8,703 gap between those two figures is the extra interest, which is the price of the arrangement stated in dollars.
Whether that trade is worth taking depends on what the $19,673 did. Sitting in the account it was a slow loss. As the down payment on a second house it may have earned more than 7%, and how much cash a rental takes to buy sets out what that next deal needs.
Why is interest only offered on rentals at all?
Because the rules that ban it on your own home mostly do not reach a rental.
A Qualified Mortgage has to have “No risky loan features”, and the first one the CFPB names is “An ‘interest-only’ period, when you pay only the interest without paying down the principal” (What is a Qualified Mortgage?). Those rules sit in Regulation Z, which covers consumer credit, and Regulation Z treats a rental differently: “Credit extended to acquire, improve, or maintain rental property (regardless of the number of housing units)” that is not owner-occupied “is deemed to be for business purposes” (official interpretation, comment 3(a)-4). The same comment says the deeming stops if you expect to occupy the property more than 14 days in the coming year.
So an interest-only period turns up on the loans written for landlords, including DSCR loans, and not on the loan for the house you live in. What the rest of that loan asks for is a separate question, and a DSCR loan next to a conventional one runs both on the same house.
An interest-only period is not a balloon, though lenders sometimes pair them. A balloon asks for the whole balance on one date instead of raising the payment, and a balloon payment worked through is the version to read if your term sheet has one.
What to check before you sign one
Three numbers, in this order.
- The date the interest-only period ends. It will be on the note, in months.
- The payment after that date. Put the balance in the rental calculator with Loan term set to the years that will be left, and read the payment.
- What the rent has to be by then. Run the cash flow at the higher payment with today’s rent. If it is negative, you are counting on rent growth, and that is a forecast rather than a term in the contract.
If the answer to the third one only works with a refinance, the loan has a condition the CFPB already named. Price the deal at the payment you will be making in year 11, then decide whether the cheaper decade is worth having.