Do you Know your Loan Amortization Options?

loan amortization

Smart real estate investing involves most of the times financing a significant part of the purchase price of a property through mortgages, that is, loans that are secured by the property that is acquired. The benefits of borrowing in acquiring a property as an investment can be considerable under certain circumstances. Loan amortization is the gradual reduction of the loan principal due to the lender through periodic payments. Notice that amortization refers solely to the re-payment of the principal due by the borrower, not payments of interest. In terms of amortization, property investment loans can be distinguished in three categories:

  1. Loans with no amortization, and, therefore, no payments of principal (interest-only mortgages)
  2. Loans with partial amortization (balloon mortgages)
  3. Loans with full-amortization (otherwise referred to as self-liquidating loans)

Interest-Only Loans

Interest-only loans also referred to as term loans, call for payment of interest only and no principal. In this sense there is no amortization.  The entire principal is due upon the expiration of the loan. The greater advantage of this type of loan for the investors is perhaps a lower monthly mortgage payment and that the debt service may be fully or partially tax deductible in the US (in the case that the mortgage is for first or second home) and many other countries that have similar provisions in their tax code. However, because this type of loan is more risky for the lender, because no loan principal is repaid, the lender will most likely charge a higher interest rate.

Lower mortgage payments can come handy to the investor, especially when acquiring property investments that may have a low initial cash flow that is expected to increase considerably due to effective management initiatives by the investor (e.g. properties that are bought originally with low occupancy rate with the purpose of increasing occupancies and rental income through effective re-positioning and marketing).

Partially-Amortizing Loans

Partially-amortizing loans (or balloon mortgages as otherwise referred to), call for partial repayment of the principal over the term of the loan with the remaining balance due upon expiration of the term of the loan. Usually the amount of principal due upon maturity of the loan is significant. The reason for the significant outstanding balance at the end of the term of the loan is because the loan amount is amortized over a significantly longer period than the actual term of the loan. For example, a balloon mortgage with a term of 10-years may be amortized over 20 or 30 years.  In other words, the annual or monthly loan payment is determined as if the full principal of the loan will be repaid in 20 or 30 years and not 10 years, that represent the actual term of the balloon mortgage.  In this way, the borrower by the end of the 10 years will repay only a part of the principal, and the significant remaining balance will be due as the balloon payment at that point in time.

Fully Amortizing Loans

Fully amortizing loans, or self-liquidating loans as otherwise referred to, are loans that call for full repayment of the loan principal by the time that the loan term expires. This is the type of financing that is most commonly used for residential mortgages in the United States, the UK and many other countries around the globe. Depending on whether the mortgages are fixed-rate or adjustable-rate the monthly/annual loan payments may be constant or variable, respectively. Note that the full interest owed is taken out first from the monthly installments, and the remaining amount goes to the repayment of the principal. Note also that as the principal owed is reduced gradually, the interest owed is decreasing (as it is calculated in each period on the remaining balance of the loan), a larger amount of the payment will go towards repayment of the principal.

Examples

Let’s see how the financing of the acquisition of a residential property valued by the bank at $500,000 can be financed under different loan amortization regimes. For all loans we assume that the investor borrows 70% of the value of the property and, therefore, the loan amount in all cases is $350,000 and the investor’s equity $150,000.

It is emphasized that the examples provided below may not be necessarily realistic under current market conditions or lending practices; they are only provided for demonstration purposes. Also notice that in these examples the interest rate assumed decreases as the degree of amortization increases. So the interest-only loan has the highest interest rate because it is the most risky for the lender, while the fully amortized loan has the lowest interest rate because it is the least risky to the lender. Note that the differences in the interest rates are completely hypothetical and may not reflect at all how lenders price loans in the marketplace.

Hypothetical interest-only loan (no amortization)

Let’s assume that the following terms apply to this loan:
Term of the loan: 5 years
Interest rate:  7%
Interest-only monthly payment: 350,000 x (0.07/12) = $2,041.67
Balance due at the end of the term of the loan: $350,000

Hypothetical partially-amortized loan (balloon mortgage)

Let’s assume that the following terms apply to this loan:
Term of the loan: 10 years
Fixed interest rate:  6.5%
Term used for amortizing the loan amount: 30 years
Monthly loan payment: $2,212.24
Balance due at the end of the term of the loan: $296,716.44

The annual loan payment can be calculated in Excel using the PMT function as follows:

Monthly payment = PMT(monthly interest rate, loan term in months, loan amount)

Plugging in the numbers in our example (without any space after or before the commas), the function PMT should be written in Excel as:

 =PMT(0.065/12,360,350000) = -2,212.24

Excel gives the payment as a negative number to indicate that it is a cost item to the borrower. In the PMT formula above the monthly interest rate is entered as the annual interest rate over 12. Also, since this is a partially-amortized loan, the “loan term” that needs to be entered is the one used for amortization purposes, which we assumed that it is 30 years, or 360 months. Finally, note that when you enter the above in an Excel cell, you need to start with the equal sign.

Once the monthly payment is calculated it is also relatively easy to estimate the remaining balance of the loan at the end of the 10th year, when it will be fully repaid by the investor as a balloon payment. This can be calculated as the present value of the remaining monthly payments for fully repaying the assumed fully amortized 30-year loan that was used to estimate the monthly installment that the borrower will be paying. Since by the end of the 10th year the real estate investor will pay 120 out of the 360 monthly installments of the 30-year fully amortized loan, then there will be 240 remaining monthly payments of $2,212.24 each. We can calculate the present value of this constant payments over 240 months using the PV function in Excel as follows:

Remaining balance =PV(interest rate, number of periods, installment amount)

Therefore, the PMT function for our example should be written as:

Remaining balance =PV(0.065/12,240,2212.24) = $296,716.44

That is the amount that will be need to be repaid by the investor at the end of the 10 years as a balloon payment in order to fully repay the loan.

Hypothetical fully-amortized loan

Let’s assume that the following terms apply to this loan:
Term of the loan: 30 years
Fixed interest rate:  6.0%
Monthly loan payment (both interest and principal): $2,098.43
Principal due at the expiration of the term of the loan: $0

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Author: Petros Sivitanides, Ph.D.

Dr. Sivitanides is a seasoned expert in real estate investment strategy and analysis, property portfolio modeling and strategic analysis, and real estate market research and econometric forecasting with over 16 years of experience with leading global real estate investment managers and real estate consultants (CBRE Global Investors, AXA Real Estate, Torto Wheaton Research, DTZ, etc.). He is the editor of the textbook titled “Market Analysis for Real Estate”, which has been used as the main textbook for a graduate course at Harvard University. He is also the author of the book "Real Estate Investing for Double-Digit Returns" and many widely quoted articles that have been published in popular real estate journals. Currently, he is the Head of the Real Estate Department at Neapolis University in Cyprus, and an international real estate consultant.

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