Should I REALLY use an interest-only mortgage as a buy-to-let landlord?
I'm considering purchasing my first ever rental property. I'm aware of the city I'd like to purchase it in and have a couple of specific developments in mind.
I'm torn between purchasing the flat for sale using a payment mortgage or an interest-only home loan.
The mortgage broker I spoke to stated that it's standard procedure for landlords to purchase properties on an interest-only basis, but to my understanding, that doesn't seem like the most financially prudent decision.
I was wondering, many buy-to-let investors opt for interest-only mortgages. What benefits are there to this approach? Isn't it more logical to stick with a repayment mortgage and reduce the debt gradually?
Buying-to-let investors are particularly drawn to interest-only mortgage deals.
For the past eight years, roughly 80 percent of new buy-to-let mortgages entered into in the UK have been on an 'interest only' basis, according to UK Finance.
When you take out an interest-only mortgage, you'll pay the interest on the loan each month, while the original loan amount remains unchanged.
This contrasts with a standard repayment mortgage where you pay back a portion of the loan sum, together with the accrued interest, every month until you've fully cleared the mortgage.
Homeowners choose interest only mortgages over repayment ones as it permits an increase in their monthly cash reserves.
For instance, a £200,000 mortgage being repaid over 20 years on a repayment mortgage at a rate of 5% will cost £1,320 per month.
A £200,000 interest-only mortgage under these conditions would work out as a monthly cost of £834.
The major drawback of taking out an interest-only mortgage is that it means the amount you owe will not decrease over time, only the interest payments are covered.
This implies that after the 20-year period, the £200,000 mortgage will still remain outstanding, whereas, by way of comparison, a repayment mortgage will see the property become debt-free at that time.
Lenders will require borrowers to demonstrate their plan for repaying the mortgage from the very beginning.
The most widely chosen method for landlords is to settle their mortgage obligation through the sale of their property, or in the case of multiple properties, another one.
A director at SPF Private Clients, a mortgage broker, was approached for their expert opinion.
What is the reason behind landlords using interest-only mortgages, also known as interest-only loans to buy a property?
Surprisingly, despite common assumption, there are actually very few compelling reasons to opt for a repayment mortgage.
As an investor, your primary concern is the risk of a cash flow problem, which could force you to miss mortgage payments and risk losing the property to repossession, possibly due to a tenant defaulting or unforeseen repair costs escalating.
With a repayment mortgage, your monthly payments are greater because you're paying both interest and a share of the initial amount borrowed, so each month you will have less disposable income to save as an emergency fund.
The thing people often overlook is that having an interest-only mortgage doesn't prevent you from paying off the capital, it simply allows you to choose when you do so.
Most mortgages permit you to overpay by a specific amount annually, and when a fixed term is completed, you may settle a sizeable portion of the mortgage capital if you wish to do so.
However, many investors prefer to keep their repayments low, mainly because, as time passes, the amount borrowed for the property naturally decreases in relation to its overall value.
That is because over time, the amount you borrow will remain the same, but inflation will likely continue to rise, increasing the value of your home.
Even if the property's appreciation in value is a mere 3% per annum, it will have effectively nearly doubled after twenty years.
It equates to the fact that if you began by borrowing 70 per cent of its value, your loan would then have diminished to approximately 40 per cent.
At this stage, you could either sell the property to clear the outstanding debt, or use a portion of the rental income you've been building up.
Borrowing money this way is a significant change of perspective, but it's only considered reckless if you overExtend yourself initially or increase your borrowing as the value of your property increases.
**For and Against Interest-Only Mortgages**
An interest-only mortgage can have some benefits, but also some drawbacks you should be aware of before making a decision. Here are the main advantages and disadvantages:
**Advantages:**
* You only pay the interest on the loan for a set period, which can make your monthly payments lower.
* You can use the money you save on loan repayments to invest or save elsewhere.
* Lower monthly payments can free up more money in your budget for other expenses.
**Disadvantages:**
* At the end of the interest-only period, you'll have to repay the full amount borrowed, which can be a significant burden.
* You may struggle to repay the loan if interest rates rise, as your monthly payments may not keep pace with the increasing debt.
* You'll need to have a solid plan in place to pay off the loan, as it will be due in its entirety at the end of the interest-only period.
* You may be charged a higher interest rate on an interest-only mortgage, increasing the amount of interest you pay over time.
The success of your investment depends on your approach: if you're thinking of buying multiple rentals, it might be wise to hold some funds back for the deposit on the next property rather than putting all your available money towards paying off the mortgage on the first one.
The benefit of interest-only is that your monthly mortgage payment is reduced to just the interest component, helping to keep monthly costs lower.
Landlords generally tended to prefer interest-only mortgages previously because mortgage interest was often offset against rental income to lower their tax liability, but this is no longer the situation, so it's no longer an obvious choice.
With a repayment mortgage, you understand that by the end of the agreed period the property will be yours, so if it suits your budget and aligns with your plan for owning a home, it's the most secure choice.
With an interest-only mortgage, you don't repay the amount borrowed, so the full loan balance remains outstanding at the end of the mortgage term.
Many landlords sell their rental properties, typically using the funds to settle any outstanding mortgage debt, leaving hopefully a surplus to serve as a profit, since they don't typically require the same level of ongoing commitment to maintaining the property that they would with their principal residence.
When investing in a buy-to-let property, it's crucial to set aside some funds for times when the property is vacant and not generating any rental income, thereby covering the monthly mortgage payments.
You should also have a rainy-day fund that covers unexpected bills, such as replacing the boiler or washing machine. If your finances are tight, building up this reserve fund may be more sensible than taking out a repayment mortgage and making bigger monthly payments.
We come across some clients who opt for interest-only mortgages, but with many lenders now offering a 10% overpayment facility with no penalties for early repayment, an alternative is to save up and make extra payments when you can.
This has the same outcome as taking out a repayment mortgage, as the extra payments reduce the capital, but you are not contractually bound to make them, so it offers more flexibility.
Another point to consider is the type of ownership you have for the property - whether it's held in a limited company or in your own name. If it's the former and you decrease the capital, the amount of interest you can claim against the rent will also be reduced.
So, the ownership structure and whether you're a basic or higher rate taxpayer also come into play here. It's worth getting advice from a mortgage broker who can look at the whole market, as well as a tax specialist.
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