Whether you’re seeking a bare land loan or looking for a comprehensive development finance solution, structuring your loan repayments to meet your cash flow requirements will enable you to control your risk and maximise your return.
Below is a comprehensive breakdown of the three repayment types; principal & interest, interest-only, and capitalised interest, and the scenarios they are most suited to. Ultimately, choosing a repayment method that suits you and your circumstances will go a long way toward facilitating your financial success.
Principal and interest loans have two components, hence their name. The “Principal” is the initial loan amount borrowed from the lender, e.g. a bank or a company like ASAP Finance. The “Interest” is the cost of Borrowing and is the extra money accumulated on the Principal over the specified loan period. This loan structure is most commonly adopted by banks for consumer homes loans, and they are designed to pay off a loan over a defined period (e.g. 30 years).
Monthly repayments are fixed and at the beginning, your monthly repayments consist of a small portion of the Principal amount, with the majority of the repayment consisting of Interest accumulated for that month. With each repayment the Principal sum is gradually reduced, meaning the interest generated each month gets smaller. With the monthly repayment amount fixed, this means a greater portion of the repayment goes toward reducing the Principal amount, and a lesser amount towards Interest. The latter part of your loan term is mostly dedicated to paying off the Principal.
At ASAP Finance, our clients are typically developers and property investors in need of short-term loans, hence Principal and Interest Loans are not often used. Instead, our clients seek to increase leverage to maximise return on equity. That said, it is important to understand P&I loans and their role in the world of property.
Interest-only loans are commonly used here at ASAP Finance. After borrowing the Principal amount, investors will only pay the interest accumulated on the Principal for the loan’s duration.
In this situation, the Principal doesn’t need to be repaid until the loan period ends. This reduces the mortgage repayments during the term of the loan and allows investors to direct their capital to other productive assets. As property values rise over time, investors can generate equity in their properties despite the fact Principal repayments are not being made to the loan.
Interest-only loans also present potential tax benefits for investors. If interest paid on a loan is tax-deductible, then paying interest-only maximises that deduction for the investor. Banks and other lending institutions typically offer a fixed term for Interest-only Loans, with the most popular period being about five years, after which the loan can revert to P&I or the Borrower can simply repay the Principal all at once.
However, interest-only loans also have a high degree of risk. The Principal still needs to be repaid and opting for an Interest-only structure defers this obligation and increases the total repayments required to repay the loan. Furthermore, funding costs can significantly increase when the term of the loan expires, and P&I repayments are required. Lastly, it is important to remember that should the property depreciate, you could end up owing more than the property is worth.
This loan type is for you if you are a property investor who is confident with managing money (often useful with commercial development finance). Astute borrowers can optimise their tax position and benefit from the lower repayments, weighing the rising equity of their property against the interest repayments and Principal amount. By the time the interest-only period ends, you should be able to repay a significant portion of the Principal as long as you’ve adequately managed your assets during the loan’s term.
A capitalised interest loan is our most popular loan structure as it is suited for property developers. Instead of paying a monthly interest expense, the interest is ‘capitalised’ onto the Principal amount each month. Once the loan matures, the Borrower repays both the Principal and the accumulated interest in full.
Most developers have their cashflow committed towards the project they are working on, making monthly repayments difficult. Lenders in the development finance industry also have a preference to adopt capitalised interest repayments as it underscores one of the most fundamental funding methods in development finance; funding on a “cost to complete” basis.
Funding on a ‘cost to complete’ basis is where the lender retains 100% of the cost to complete the project, no matter what stage the project is at. Under this scenario, Interest repayments are viewed as a project cost, meaning the lender will retain the total expected interest cost within their loan facility. Each month, interest is drawn from the ‘capitalised interest facility’ and applied to the balance of the loan.
One of the important things to note about a capitalised interest loan facility is that interest is charged on the drawn portion of the loan, so the amount capitalised onto the Principal is not static from month to month.
For example, you may only draw 20% from the Loan Facility in the first two months of work, so interest is only charged on 20% of the Principal. At six months and 60% drawn, interest is charged on 60% of the loan amount.
Simple: this loan structure is for you if you are a developer. Adopt a clear plan for your development and you’ll be able to repay the Principal and interest upon completion of the project.
Funds for construction and development loans are only drawn down from the Loan Facility as and when they are required to fund each stage of the build. Smart borrowers with a clear plan for their developments can capitalise on this structure due to its unique interest scheme, as the actual interest paid by the Borrower is typically between just 55% to 70% of the headline interest rate charged by the lender.
Furthermore, delaying the interest liability gives the Borrower time to generate revenue before they must repay the loan amount.
Our lending managers are experienced in all areas of property development, and we tailor a bespoke loan package to suit your needs. Talk to the Kiwi leaders in non-bank property finance for a hassle-free lending journey today.
Written by Ben Friedlander