The pros and cons of interest-only mortgages
When assessing the financing options for investing in property, one of the key questions to answer is if you should use a repayment mortgage or interest-only mortgage. This article will help you decide, as we point out the advantages and disadvantages of both types of mortgage when you invest in buy-to-let property.
What is the difference between interest-only and repayment buy-to-let mortgages?
Most property investors use interest-only mortgages to finance the purchase of residential investment properties. This may seem strange to you, as with a repayment mortgage, by the time the mortgage term ends, the mortgage will be repaid. All proceeds will be yours to keep (after capital gains tax, of course).
With an interest-only mortgage, at the end of the mortgage term, you will still be required to repay the capital you borrowed on the mortgage. That might be concerning; will you be able to find the money to repay the mortgage, or will you be forced to sell the property to satisfy the repayment?
The advantages of paying interest only on property investment mortgages
The main advantage is that the monthly payments are cheaper because you are not paying down the capital borrowed. The benefit of this is that your expenses are lower, and therefore your cash flow is better.
For example, if you borrow £150,000 and the interest rate is 4.5%, the monthly payment on an interest-only mortgage will be £562. This is a saving of £271 per month on the payments you would need to make on a repayment mortgage (which would cost £833 per month).
The money that you would have otherwise used to make the capital repayment part of a repayment mortgage can be used for other means; for example, to pay other costs of owning your buy-to-let property, as extra income to let you work fewer hours, or to save towards the deposit for further property investments.
The tax advantage of interest-only buy-to-let mortgages
When you buy an investment property, you can claim tax relief on the interest that you pay on the mortgage. While this benefit is being eroded for higher rate taxpayers, it is still a valuable benefit to have. This tax relief is only available on the interest payments, and not on any capital repayment you make.
(See our article “How will the change to mortgage interest tax relief affect me as a property investor?” for more information.)
The disadvantage of interest-only mortgages
There is a downside to investing using an interest-only mortgage rather than a repayment mortgage. This is that if the property price falls and is lower when the mortgage term ends, you must pay more than the property is worth.
If you have relied on the property price rising so that you could sell your property, repay the mortgage, and bank the profit, a fall in price could leave you short of your target. Furthermore, you will have to find the balance between the property’s value and the outstanding mortgage balance to repay the mortgage.
While you must consider this possibility, over the long term, UK property prices have doubled every eight to 10 years. For an investment property to be valued lower than its original purchase price some years earlier, the market will need to go into a prolonged and severe downturn – perhaps not impossible, but highly improbable.
Whatever your investment style and risk, if you have borrowed to invest using an interest-only mortgage, you will need to repay the capital at the end of the mortgage term. Many investors do so by remortgaging, repaying the capital owed from other sources, or selling the property.
However, you may also consider mitigating the risk of not being able to repay the capital borrowed by planning other ways to repay. You might, for example, save positive cash flow in a cash ISA, or invest in a different investment asset.
Which mortgage is best for you?
As you’ve seen, most landlords invest using an interest-only mortgage because it:
- Boosts cash flow
- Retains tax benefits
- Allows the investor greater flexibility (to use the better cash flow in different ways)
However, if you need to sell in a weak market, then you may not raise enough money to satisfy the outstanding debt. It is likely that an interest-only mortgage will be the most advantageous strategy to finance your property investment, but it depends on many factors, including your investment goals, risk profile, and personal financial circumstances.
For a confidential meeting to discuss whether property investment is right for you, contact Gladfish today on +44 207 923 6100 and book a strategy consultation. We’ll discuss your goals and financing options, among many other aspects of property investment, and ensure that you are fully informed with all the facts to help you make your decision.
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