Re: interest only loans - refi now? - Posted by John Corey
Posted by John Corey on April 12, 2006 at 16:37:39:
Why do you think an IO loan is not a good or not the best idea? A 30 year fixed loan will only pay off a very slight amount of the principal in the first 5 years.
Lets crudely look at the normal life cycle.
You buy a rental. You have tight cash flow during the initial years. You then see the rents rise. You need to put aside some cash each month to create a reserve for maintenance, vacancies, other costs related to a new tenant, and long term capital improvements.
How does putting a bit of money each month into the property to pay down the loan help? The cash is then trapped so it is not easy to pull out. Most of the time when someone refi’s to get to the equity they are mostly pulling out appreciation and not debt reduction from the monthly payments.
Say you own the place for 10 years and then either sell or trade up (1031 vs. a sale). In either case the amount of equity you would have from the loan pay down is almost nothing compared to the appreciation. If you happen to be investing in an area that has little appreciation the equity will be from a loan pay down only and it will be minor. If you pour extra cash into the property vs. hold it in a saving account you are still going to pay taxes on the principal pay-down or savings (adjust for depreciation - still does not change much).
So, I would rather have the spare cash where I can get to it when a heater goes, a roof needs replacing, a tenant moves out in the night. The only exception might be if I had a HELOC as that allows me to reduce the debt and then jack it back up when I need to cover some running costs.
Now, do not confuse this advice with thinking a floating interest rate product is the best. I am saying interest only, not a floating rate interest only. Any loan that has interest rate adjustments carries interest rate risk and that risk does not change if you happen to pay down a bit of principal or only pay the interest portion.
You can manage floating interest rates by having gaps or other restrictions on the rate of change or the index used. Interest rate risks is a separate topic.
Focus on lots of positive cash flow and hanging on to the capital so that you can cover the bad patches. Use conservative assumptions. Do not worry about principal pay down as it does not happen quickly and tends to tie your hands if you needed to cover the smaller running costs.
I do some investing in the United Kingdom. The banker’s there think you are a bit odd if you want to pay down the debt on a rental (‘Buy-To-Let’ - BTL is the UK label for a rental). They view the financing as working capital and expect that it will be paid off when you sell the property. They ask why a borrower wants to put more equity into the property each month and reduce the return on the invested capital (reducing the leverage). All investor loans are ARMs and a 1-2 year fix before a monthly floating rate is the norm.
PS. One other idea to consider. Pay down the personal residence and have a HELOC in place for a rainy day. That debt is more of a liability. If something nasty happens you can afford to lose the rentals and take the credit hit if your primary residence has little to no outstanding debt. For the most part a lender will come after the rentals and not go after the primary residence if you default on the loans on the rentals. Not as black and white as this might sound but I think you understand the point.