Interest-only mortgages are a waning market in the residential sector, particularly since April’s Mortgage Market Review tightened the screws on affordability checks and ruled out this riskier type of borrowing for all but a few high net worth customers.
In the buy-to-let market, however, interest-only dominates. On the surface, it can be hard to see why, as the downsides are clear:
- With the capital debt remaining the same, the overall interest bill is higher
- Without a repayment strategy, you will likely have to sell your property to repay the debt
- With a higher LTV (loan-to-value) ratio, there is a greater likelihood of falling into negative equity
Conversely, the benefits of having an unencumbered property are obvious; your mortgage is one of your biggest expenses, if not the biggest, and with it out of the way, your income will be substantially boosted.
So why do most landlords opt for an interest-only buy-to-let mortgage?
You might think that your debt will remain the same if you don’t repay your capital, but in real terms, this isn’t strictly true.
Among investor jargonese is the term ‘time-value of money’ (TVM). It refers to the potential future value of any money that can accrue interest, and the principle holds that any amount of capital is worth more now than it will be in the future.
When the principle is applied in reverse, it can refer to debt. Over time, any and all debt is eroded by inflation, so theoretically, so long as inflation is positive (and you keep on top of your interest repayments), your debt will effectively shrink. Nominally it will be the same, but in real terms it will be lower.
Risk and reward
The ethos that higher risk means higher rewards is central to business. One of the many risks in buy-to-let is that your property might diminish in value, with the concomitant reward being the potential for capital gains.
The bigger your debt is, the bigger your potential risk and potential reward will be. Consider a fairly ‘safe’ mortgage of 60% LTV versus a comparatively risky mortgage of 80% LTV. If you own 40% of your property outright, a relatively small gain in value of 5% will mean that your return on investment is 12.5% (5 / 40 = 0.125); whereas if you own just 20%, the same increase in value will constitute returns of 25% (5 / 20 = 0.25).
Essentially, halving the amount you invest potentially doubles the amount you can make – or lose!
The tax argument for interest-only mortgages is a fairly common one. HMRC allows you to offset your running costs – including mortgage interest – against your income when calculating income tax. The higher your mortgage interest, the less tax you pay.
As your interest bill reduces over the period of a capital repayment mortgage, your tax bill will gradually increase. As a general rule, the tax savings you could make by offsetting an interest-only mortgage wouldn’t exceed the interest you would save by repaying capital. But the smaller the capital reduction, the narrower the savings margin, and you might feel that the funds would be better spent on expanding your portfolio or increasing your equity by renovating your existing properties.
Which brings us onto…
Top of the bill is the main reason for the popularity of interest-only mortgages among property investors – cashflow.
If you have a capital repayment mortgage, you slowly erode the debt secured against a single property. In effect, you are investing the money into an unencumbered asset.
However, you might prefer to invest that money in increasing the value of the property. You might prefer to use it to purchase other rental properties and expand your portfolio. You might prefer to save it, or invest it elsewhere. Given the choice, you could make more money than you would save by reducing your interest bill.
All businesses need an operating income to survive, which means cashflow is a key consideration to anyone approaching buy-to-let as a business rather than a ‘nest-egg’.
So, as always, the decision between interest-only and capital repayment hinges on why you are purchasing a property and what your plans are. If, for instance, you are an ‘accidental landlord’ renting a property you are unable to sell, or simply looking for a boost to your retirement income, capital repayment might be the better choice (if you can afford the repayments). If, on the other hand, you are running a property investment business, you might find that interest-only is better suited to your needs.
Your home may be repossessed if you do not keep up repayments on your mortgage
The FCA does not regulate some forms of buy-to-let or commercial mortgage.