Interest Only or Repayment – what do you do believe and why?

Hi Dan

I would like to pick up on the point you have made regarding lenders calling in loans.

First off, you need to check your T&C's to ensure they can do this unless you are in default. Then you need to check what their basis of default is. For example, if their T&C's allow them to re-value your property at any time, then to call the loan in if your interest cover or LTV falls below a certain margin then don't sign up. If in don't seek professional advice. If your loan contains these terms then you have a commercial decision to make in respect of whether you take that loan or not. I believe this was the crux of the matter in respect of the case you have cited in your post.

My second point addresses your point regarding having a cash reserve. If you don't have a cash reserve then how will you be able to employ a legal team fight off any unreasonable challenges your bank throws at you?

As you have stated, my reasons for advocating interest only are well laid out in the property investment strategy which I have documented on this website, the article most relevant to this topic being >>> http://www.property118.com/interest-only-vs-repayment-mortgages/ but it really must be read as a part of the overall strategy as opposed to a stand alone piece.
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Hi Dan

If your mortgage lender did call in your loan would you prefer to have a lower loan balance or a bigger bank balance?

It is important to build a cash reserve for many reasons, reducing your costs of letting and void periods is a great way to do that. The guide linked below provides some useful tips on how to achieve that.
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BTL is categorised as commercial borrowing and what business would refuse the option of an interest only loan?

Dan,
I think you are asking the wrong question.
I used to work for a large multinational in their 'investment screening' division. The policy there was to evaluate projects as stand alone ventures. - ie no financing. Financing was evaluated separately. The reason for this applies equally to BTL.

Yes you can get loans secured against the property and you should evaluate each option to see which is the best. The reason the financing was looked at separately was that although specific project (house) finance is available, at the end of the day if the project (house) did not cover the project (house) loan the lender always has the option of getting the company (you) to pay up the difference.

Mathematically this is the correct way of looking at it. The risks for each (loan and house) are different. The BTL project is more risky than the loan.

So my answer is simple. You take the cheapest affordable option whether repayment or interest only. Sometimes this may be out of your control because of banks' policies. - Try getting interest only residential mortgages today - repayment is now the only option from the big banks.

Finally remember your equity has a cost too. That cost is the alternative investment option for the money be it bank or shares. Some people take the long term view that shares return about 7% on average.

To a large extent interest only or repayment depends on your exit strategy, and your attitude to risk.

To me interest only is better for portfolio growth as your mortgage payments are less and so it is easier to refinance up to the hilt. Had I aggressively gone down the diligently refinancing at every opportunity I would probably now be sitting here with over a million pounds of mortgage outstanding on an interest only basis and possibly at risk of lender shenanigans claiming breaches of LTV levels as an excuse to get the LPA receivers in. (ie: a relatively small dip in house prices could put you in trouble)

OK, even without that last bit, I would still be sitting here with a large amount outstanding such that I couldn't even cover the interest payments out of my working income. I would then also be dependent on lots of inflation and house price rises in order to erode the value of the outstanding debt.

At the end you are left with the issue of how to repay. Either you've been saving up elsewhere and been both able to invest at a rate higher than the mortgage interest and disciplined enough not to spend the money on something else (if so, well done). Or you need to start selling things to repay the mortgages, which is likely to involve hefty CGT issues. Or, as in the other recent thread, you try and remortgage everything to lifetime mortgages and try not to worry too much as the balance outstanding increases by about 6% every year (if you have enough capital in your owner-occupied property to cover that, as I'm not sure you'll get lifetime mortgages on BTL (maybe you can but I'd expect the rate to be higher still)

Instead, I've gone down the repayment route. OK, I'll concede that with the rental income it is less tax efficient, but the return I get on mortgage repayments even after tax, is still better than from bank accounts, although not as good as my _current_ stock market returns.

I can sit here and not feel too nervous as I know that my mortgages outstanding are currently falling by about 5% per year, my LTV is now less than 30%. My non-rental income is sufficient to cover those mortgages if need be. Unless I buy any more I expect to be mortgage free by the age of 50, albeit with a smaller portfolio than had I gone interest only, and with a slightly larger tax bill right now.

So going interest only you need to consider your exit strategy and the level of risk you are prepared to take with the money that you aren't using to pay down the mortgages.

I am a strong advocate of interest-only too, preferably with an offset mortgage. Let's say you have a £200K mortgage. Via savings, windfalls and surplus rental income, you build up a lump sum of £50K. You could keep a reserve of £10K and pay down the mortgage by £40K, but what good does that repayment really do, besides your peace of mind that the mortgage is now smaller? If you keep the cash, you still have £50K, so if there ever were a crisis, such as a sudden large increase in interest rates, or your lender did for some reason call in the loan or demand a reduction in its size, you would have the cash as a bulwark. And if you keep the cash in your offset facility, it's already protecting you against some of the interest-rate rise anyway. Or you can invest the cash elsewhere and get a better return that you are paying out because you have a larger mortgage.

Ultimately cash gives you flexibility to deal with all eventualities, both in your rental business and your private life. If you pay down your mortgage, the cash is no longer yours - it's in the hands of your lender - and you lose all that flexibility.

As long as you know you have the personal discipline to harvest your cash lump sum and invest it wisely, as you hopefully have done already by buying your rental property in the first place, I really can't see any long-term advantage in paying down a mortgage.

Dan,

I've seen heard several discussions on this topic and while many may have compelling opinions to go interest-only- I think, it really depends on your personal circumstances & end-goal. I think Mark's advise is pretty strong - but it doesn't fit with everyone’s plan, so I'll state where I'm with it.

My plan is to aggressively build a portfolio that will be mortgage free (equity-rich) by the time I get to 50 (17 years to go) - I then either coast myself into retirement (with rental income alone) or sell the whole-lot to extract the funds for other good things in life.

I currently own 6 privately-rented properties. 5 off them have repayment mortgages and the last one on an interest-only mortgage. I fund my property purchases from either saving-up (from employment) or from gains (through other investments). The purchases where all made since 2005.

The property with the interest-only mortgage is on ridiculously low interest rate, hence the reason to leave it on interest-only (cheap credit) BUT I hold what would have been the rest of the repayment amount in a (stock/share) investment account. The remaining mortgages have rates varying between 1.5 to 4% interest rate and LTVs ranging between 60-75% - these are all on repayment basis, in order achieve my target to be debt-free by 50.

Mark might now argue – “instead of paying off your mortgages - why don't you save up & buy more properties”. I would ask, how much does one actually end up saving up by not making full repayments instead of interest-only? I think it averages about £1-2K for a £100K value property on about 75% LTV and a 4% mortgage. Whereas to fund a new purchase, you will need about £20-25K!

To summarise, if one has the emergency funds to sort breakdowns and an income stream to grow their portfolio, then I would advise they keep their mortgages on a repayment basis.

I am in the property business, because of the buzz it gives me in sourcing & buying property at the right price and trying to improve my previous year’s financial performance – currently running at 14% net ROI and 33% net ROR.

Hope this helps.

Some One, you been reading my mind or vice-versa! Glad I'm not the only one thinking the way I do 🙂

Reply to the comment left by "Tony Atkins" at "16/01/2014 - 13:00":

Hi Tony

I have been distrustful of offset mortgages from the day they were first introduced into the UK. I would rather get a lower return on my cash and know for sure that I really can get at it when I want it. Obviously there are some basic rules to follow, e.g. make sure you take maximum advantage of tax free savings accounts, seek out the highest interest rates and never invest more than £85,000 with any one financial institution so as not to be exposed beyond the Financial services compensation Scheme limits.

My mistrust of the offset mortgage principles has been proven to have been well placed several times in recent years due to the likes of Barclays/Woolwich and Bank of Scotland having all decided to withdraw the ability for their borrowers to draw their money up to a pre-agreed credit limit. This left thousands of small businesses in dire straights as many of them used these types of facilities for cashflow purposes and even as savings accounts for their tax bills. The banks did, of course, give notice as per their small print but thousands of people failed to recognise the importance of the communications or missed them due to being on holiday or problems with receiving their mail. As a result, many people who genuinely believed they still had access to their full credit limits got caught out and suffered severe financial hardship when they went to draw money back from their offset accounts only to find that their new credit limit had been capped at their account balance on the cut off date.
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Reply to the comment left by "Neil Patterson" at "16/01/2014 - 12:35":

Hi Neil, I am new to the game looking at it from the point of view of investing, rather than just buying a place to rest my sofa and eat some chips ;-). It probably sounds incredibly naive but isn't it a better business that has fewer debts??