Interest only vs repayment mortgages

Mark Alexander founder of Property118.com

A common question from new Landlords is why are so many BuytoLet mortgages taken out on an Interest only basis rather than Capital and Repayment.

First of all it helps to understand that a Buy to Let mortgage seems very similar to a residential mortgage, but it is not regulated in the same way by the Financial Conduct Authority FCA (the FCA has now replaced the FSA). This is because it is treated as a commercial loan, and investors are assumed to have a greater understanding of the commitments they are entering into than someone who may have no financial understanding buying their own main residence. The key is that a Buy to Let is seen by regulators as a business loan and Buy to Let investors should treat their property purchases using a mortgage as a business themselves.

If you were to offer any business, no matter what the industry, the option of:

• a loan on interest only with lower monthly payments or
• a capital and repayment loan with higher monthly commitments but a reducing balance

Nearly every business would choose interest only, because as the saying goes “Cashflow is King”

Now in practical terms, the biggest risk to a landlord is not being able to make the monthly mortgage payments. Therefore, this risk is reduced using interest only.

But what about reducing the loan size I hear you cry.

Interest only should hopefully produce a cashflow surplus on a reasonable yielding property and this should then be saved in a separate account for a rainy day to cover future mortgage payments, or used at your convenience for further investment or to pay lump sums off the mortgage when there are no redemption penalties.

The control is now in your hands and not the lenders, vastly reducing your exposure to risk. If you take out an interest only loan it is easy to get the lender to convert this to capital and repayment, but the reverse is true with lenders being reluctant to convert a mortgage to interest only from capital repayment when you need to.

If you are sensible and treat all your rental income as part of the business e.g. don’t rush out on holidays or buy a Ferrari, you can now manage your cash flow and total debt outstanding yourself.

The great thing about property is that over the long term it is an appreciating asset. 20 years down the line, inflation will have had a positive effect on rental income and capital values, but the loan outstanding on an interest only mortgage will remain the same as day one. In effect, inflation will have reduced the real value of the loan.

Given that none of us are immortal and that our properties will be moved on to somebody else at some point, the most likely exit route to pay off the loan will always be the sale of the property. Why, therefore, put strain on your cashflow by opting for a repayment mortgage, only to remortgage to raise cash again at some point, with all the costs incurred with that?

Another consideration is tax. You can only offset interest against rental income as an expense for tax purposes (limited companies only as of 2017) and not any capital repayment element. Therefore, with a repayment mortgage the actual cost increases year by year as the interest element reduces and the capital element of the repayment increases.

It is important to note that this strategy is not available or right in all circumstances, but a summary of why it is extremely popular for Buy to Let investors.

Paying loans down

I’m often asked “should I use the extra cashflow to reduce my mortgage balances?”

Well I suppose it depends on how much interest you are paying and whether you can get a similar rate of return elsewhere. If you are paying the eye watering interest rates of credit cards or bridging finance then the answer is probably. Some people don’t think this way though, they don’t even apply logic. Why would a person repay cheap debt only to pay fees to borrow the money back another day at possibly a higher rate? Also, if you are going to repay borrowed money, please pay off the debt with the most expensive interest rate first. If the differential between that interest rate you are paying to borrow money isn’t much different to the interest rate you return for keeping it liquid I say go with the liquidity option every time.

One day interest rates will go back up again and the base logic, for what I consider to be the incorrect decision to repay cheap debt now, is to reduce payments in the future. However, if property values fall it gets harder to borrow. When dealing with a crisis position, e.g. a desperate need for cash or unaffordable mortgage payments, would you prefer to have a slightly smaller mortgage or extra cash in the bank?  Why pay debt with low margins and then borrow back at higher margins when you need cash?  Property Investment involves positive cashflow and management of liquidity.  In my opinion, there is no sensible argument for making capital repayments on the mortgage, especially if you are still expanding your portfolio or may need to access funding for other purposes.

Fixed or variable?

Another question is whether to remortgage for fixed rates. None of us has a crystal ball so it would be remiss of me to advise you not to do this. However, if your existing mortgage is on a tracker you should compare the margin over base rate you are paying now to similar tracker products currently being offered by the same lender you are thinking of remortgaging onto a fixed rate with. If they are similar then fair enough. It’s probably fair to say the banks have a far better insight into what interest rates will do over the period of a fixed rate than most people. Therefore, any fixed rates mortgages they are offering now will be priced on what they think interest rates will average, then they will add a margin for error, then they may add their more expensive margin. The result is, if you refinance onto a fixed rate that includes a higher profit margin for the bank the odds suggest that you will lose out. It is also highly likely that you will lose flexibility and pay lots of fees.

That leaves just one question then. Why do some people refinance for what appear to be worse deals? The answer is usually that they missed the boat. If they could turn the clocks back they would have refinanced to release equity when they could borrow 90% LTV at base plus 1%. However, they’ve now realised the error of their ways, they’ve recognised that property is now comparatively very cheap and that that yields are strong and improving.  Accordingly, they are refinancing to release equity, despite having to pay far higher interest rates, on the basis that the extra cash will fund new purchases and the gains from those purchases will outweigh the extra costs.

If you would like to view the most popular Buy to let mortgages available in the market today, see how much you can borrow and what it would cost please feel free to CLICK HERE to use our Buy to Let mortgage sourcing calculator.

Want to learn even more? My buy to let property investment strategy is documented and constantly updated in the Advice section of this website. To get back to the main menu >>>