The pros and cons of interest only mortgages for investment financing
Most property investors reap the benefits of leveraging in property investment by opting for an interest-only mortgage. But as the amount of mortgage interest tax relief that higher rate taxpayers can claim is reduced and interest rates rise, might you be better advised to invest with a repayment mortgage?
How does a repayment mortgage work?
There are three major parts to every mortgage deal:
- The capital borrowed
- The interest charged on the capital outstanding
- The fees charged (which are usually added to the mortgage capital borrowed)
For repayment mortgages, the lender works out the total amount borrowed and charged interest on it. With every payment you make, you also repay a slice of the capital outstanding.
Over time, the amount you owe reduces, as does the amount of interest you pay (providing the interest rate remains unchanged). This means that you repay more of the capital owed with every payment you make.
How does an interest-only mortgage work?
Instead of making payments off the capital outstanding, you only pay the interest over the term of the loan. This means that when the mortgage reaches maturity, you will still owe the amount of capital you originally borrowed.
Homeowners are more likely to finance their purchase with a repayment mortgage. They don’t want to be left in the perhaps difficult position of needing to sell their home to repay the capital borrowed. So why do investors tend to use interest-only mortgages?
5 reasons why property investors finance interest-only
There are several reasons why property investors use interest-only mortgages rather than repayment. The main ones are:
1. Cash flow
By paying interest only, you maximise your cash flow. The mortgage payments are lower, and the cash ‘saved’ can be used for other purposes, such as saving towards the deposit for your next property investment.
Some lenders will allow you to pay lump sums off the capital outstanding without penalty. This provides a lot of flexibility for investors. When cash flow is strongly positive, you can pay down some of the mortgage debt, and reduce your interest payments (thus increasing cash flow in the future). If cash flow is temporarily weaker (for example, because of an unexpected void period), you won’t have to make capital repayments.
3. Capital growth will repay the mortgage
If you’re investing over the long term, then you would expect the value of the property to increase during your holding period. By the time the mortgage is due to be repaid in full, the value of the property should be more than enough to cover the capital borrowed and leave a sizeable profit should you decide to sell. Or you could remortgage if you intend to continue to hold the property.
4. Tax relief
As an investor, you can claim tax relief on the mortgage interest you pay. While this is to be limited to the basic rate of tax by 2020, it is still a valuable tax advantage that is not available on any repayments of capital.
5. You can invest in higher-priced property
As the repayments are lower, you can afford to invest in higher priced properties (providing, of course, you have the deposit to do so).
The disadvantages of an interest-only mortgage as investment financing
It would be wrong to consider interest-only mortgages without discussing the drawbacks for investors. These are:
· Lower equity
As your property grows in value, the equity in it increases. However, because you haven’t repaid any of the capital borrowed, the equity in your investment property won’t increase as fast, nor by as much.
· Greater risk of negative equity
If house prices fall, there is a greater risk of your property falling into negative equity. This said, with the deposit of 25% or more, you have a substantial cushion against this happening.
· You may have to sell to repay the capital owed
If you reach the end of the mortgage term and cannot refinance or repay the capital out of other means, you may be forced to sell the property. If forced to sell, for this reason, you may need to accept a lower price than otherwise. In addition, a sale may create a capital gains tax liability. When added to the costs of selling (e.g. estate agency and lawyer’s fees), you could end up with much less than you anticipate.
Which is the best property investment strategy – interest only or repayment?
As you can see, when you finance your investment using an interest-only mortgage, your cash flow is much stronger. However, you will never repay the capital borrowed (unless allowed to make such repayments). At the end of the term, you will still owe what you borrowed.
With a repayment mortgage, your cash flow is lower; but, at the end of the mortgage term, you own the property outright.
Which financing option you choose will depend upon factors such as your personal circumstances, the strength of your portfolio, and your investment objectives (for example, do you want cash flow while you own the property, or a larger lump sum when you sell?).
The way to make sure you choose the best type of mortgage for your property investment is to talk with an experienced property investment consultant, and then benefit from using a buy-to-let mortgage broker to get the best mortgage deal.
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