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When investing in real estate with the intention of renting them out, do they amortize the mortgage or do they just pay the interest rates?

What I mean is, say you plan to buy a house, rent it out for X years, then sell it.

During those X years, your monthly cash flows are rent payments coming in from renter, and mortgage payments (plus other costs) going to the bank. but if you only pay interest, and not amortizations, your monthly cash flow will be larger.

If you plan on getting rid of the house in 5-10 years anyways, and never actually hope to pay it off, is there any point in amortizing it? e.g. you could go with a 30 year mortgage that does not amortize for the first 10 years, and then after those 10 years, you just sell it at the going market price.

Which of these two strategies are commonly used, and why?

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  • Is this question from the personal tax perspective or accounting perspective? What jurisdiction is this? – base64 Oct 13 '20 at 15:03
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    What is your jurisdiction? Legal requirements matter a lot for a proper answer. – Grade 'Eh' Bacon Oct 13 '20 at 15:42
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In a completely unregulated market, whether you amortize the loan from the bank [a typical mortgage arrangement] or pay down principal in planned or at-will installments, or even pay no principal (or even no interest!) at all until the end of the loan term, is a negotiating point between you and the bank.

The lender generally wants principal payments early and often, to minimize their risk. The borrower generally wants to avoid early principal repayments [or if they are very risk conscious themselves, they may also want to pay principal along the way - and most individuals borrowing for homes tend to be somewhat risk averse, whether they think that way or not]. Other negotiating points would include the rate being charged, down payment required, etc etc., so this just means that if you theoretically wanted a 30 year bullet loan with no payments until year 30, a lender might do it if you agreed to an increased interest rate along the way.

So why does the common mortgage arrangement have you pay amortizing principal along the way?

(1) Ease of understanding - You exactly know your monthly payment, every month, forever, so a less financially minded individual can still reflect on how that payment fits into their monthly wage.

(2) Reduction of risk to the bank - individual borrowers for home mortgages are generally risky, so the bank doesn't want a 30-year bullet loan handed out to someone who might, for example, die in year 29, or lose a job in year 20, or whatever. The bank partially offsets this risk by having the right to sell your house to make themselves whole if you default, but risk does still remain, and here they can reduce that risk by getting principal repaid along the entire life of the loan.

(3) Reduction of risk to the borrower - an individual borrower could theoretically avoid paying down principal on the loan, invest it in the market for 30 years, and come out in year 31 with a mortgage completely paid off and money left over from gains realized in the stock market. Of course, such a person might 'forget' to invest that principal along the way, and be left with a $300k mortgage at 65 years old, with no cash in the bank, and be forced to sell their house to pay that mortgage off. As well, even someone who astutely invests those funds might lose them at the end in a stock market crash, and be in the same situation.

As to your question - 'why wouldnt someone want this if they were going to sell in year 5 anyway?', what happens if the real estate market goes down in year 4, and you need to sell? Will you have cash on hand to cover off the extra mortgage principal that needs to be paid? Also, will you be earning enough from the extra cashflow to be paying the additional interest every month?

(4) Government regulation - in light of the above 3 points, most governments regulate mortgages to require the protection inherent in an amortizing loan. The US had less of this regulation prior to the 2008 Global Financial Crisis that started with the 2007 Housing Crisis, where among other things, people often had 'balloon payment' mortgages with no principal owing for the first 5 years, which only works if the housing market goes up! up! up! Governments don't want to bail out the banks (again), and they don't want to have to pay for housing for destitute seniors, and they don't want morally bankrupt banks to financially bankrupt individuals with usury lender practices. So instead they require certain tests to be met for residence lending to occur, including the need to pay principal down along the way, limiting everyone's risk.

SO - knowing the above, does it work the same for non-residence lending?

Yes and no - the issues raised in #1-3 above still exist, and this is all a negotiation with the bank. The big difference is what regulation there is to protect you as the borrower and the bank as the lender. That will depend on what regulations there are in your jurisdiction, but typically the regulations are in some ways looser and in some ways tighter for rental unit lending. Among other things, the bank considers investment borrowing riskier than residence lending, because with residence lending, if you run away from them after a market crash, you will have nowhere to live, and thus you are more motivated to make those mortgage payments any way you can.

So this is a conversation you need to have with possible lenders, and needs to be in light of whatever government regulation exists where you are.

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