Interest-Only vs. Repayment Buy-to-Let Mortgage: Choosing the Right Option

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If you are planning to finance your buy-to-let (BTL) property investment with a loan, you will typically have two types or mortgage to choose from, an interest-only or a repayment mortgage. Understanding the nuances of each can help you make a decision aligned with your financial situation, plans for the property, and overall investment portfolio and goals.  

Interest-Only Mortgages

Interest-only mortgages are a type of mortgage where you only pay the interest on the loan each month and the entire principal amount is only repaid at the end of the mortgage term. By contrast, with repayment mortgages, each monthly mortgage payment consists of both principal repayment and interest. Thus, interest is paid on a reducing loan balance during the life of the mortgage and the principal is fully repaid by the end of the mortgage term. The total amount of interest paid under an interest-only mortgage is typically greater than that under a repayment mortgage.

While an interest-only mortgage may improve your monthly cash flow during the life of the mortgage, it is important to remember that the entire loan amount still needs to be repaid at the end of the mortgage term as a single lumpsum, which can be daunting prospect. It is imperative to have a robust strategy to plan for this repayment. It may be that you will want to sell the BTL property to repay the loan. Or, you might have made other investments which will sell in order to be able to repay the loan.  

Benefits:

- The lower monthly payments could reduce cash outflows and enhance liquidity.

- You could allocate these funds to support another BTL property investment.

- Or, you could allocate the funds to other investments.

Considerations:

- You need a robust strategy to repay the full loan amount at the end of the mortgage term, whether this involves selling the property or other investments.

- If the value of the property declines, there is a risk of negative equity. Likewise, the value of investments can also decline. So, it is worth building an appropriate buffer into your financial planning.

Repayment mortgages

Repayment mortgages are a popular way of becoming a homeowner, although less common with BTL landlords. As noted earlier, each monthly mortgage payment consists of both principal repayment and interest. Thus, interest is paid on a reducing loan balance during the life of the mortgage and the principal is fully repaid by the end of the mortgage term.. Compared to interest-only mortgages, repayment mortgages generally result in higher monthly payments. Still, they come with benefits such as the repayment of the loan by the end of the mortgage term, the steady build of equity in the property as the loan is repaid and paying less interest over the life of the loan. 

However, higher monthly payments can strain cash flow, particularly if the rental income from the BTL property does not significantly exceed mortgage costs. There are also other costs to be considered, such as letting agent commissions, property management fees, service charges, insurance premia, and repair and maintenance expenses.

Choosing the Right Option: A Balancing Act

A chart of a comparison between a mortgage and a loanDescription automatically generated

The decision between an interest-only and repayment mortgage depends on various factors, including your financial situation, cashflow needs, plans for the property, risk tolerance, and overall investment portfolio needs and goals. For instance, investors focusing on short term cash flow management might prefer interest-only mortgages because they want to free up cashflow for other purposes. On the other hand, those with a longer term horizon might opt for repayment mortgages for the added security of steady loan repayments and potential interest savings overall.  

The unpredictable nature of interest rates can also be a consideration. If mortgage interest rates rise dramatically, as they have done in recent years, the incremental negative cashflow impact on those with interest-only mortgages can be harsher than on those with repayment mortgages, especially where the latter have been substantially paid down already. 

If you do decide to choose an interest-only mortgage, it is crucial to have a solid plan for repaying the borrowed amount at the end of the mortgage term. Here are some common strategies:

Sell the property and pay off the principal from the sale proceeds. This strategy works well if the value of the property has appreciated over time and the price is high when you come to sell it. You can repay the loan comfortably from net sale proceeds after deductions for capital gains tax and selling costs and you will still have made a good return on your original equity investment with the left over net proceeds. However, this strategy will not work well if the property has not appreciated in value and the price is weak when you come to sell it. It can be particularly challenging if there is negative equity.

Make other investments and generate enough returns from them over the life of the BTL mortgage such that you are able to repay the BTL loan by selling investments. This approach will ideally require a robust long term portfolio investment strategy. However, there is a risk that investments may not perform as well as expected.

Whichever route you choose, it is worth seeking professional financial advice to determine the optimal plan for your particular situation. It is also worth bearing in mind that you might need to adapt your plan, over time, depending on how the market environment and your own financial situation evolve and change.

Conclusion:

In summary, your choice between an interest-only and repayment mortgage should align with your financial situation, cashflow needs, plans for the property, risk tolerance, and overall investment portfolio needs and goals. The situation can evolve and change over time, of course, so you may also need to adapt your approach. Consulting a financial advisor who can provide tailored advice can help you navigate your entire BTL and investment journey.

FAQs:

Q. What is the key difference between interest-only and repayment mortgages?

A: Interest-only mortgages are a type of mortgage where you only pay the interest on the loan each month and the entire principal amount of the loan is repayable only at the end of the mortgage term. With repayment mortgages, each monthly mortgage payment consists of both principal repayment and interest. Interest is paid on a reducing loan balance during the term of the mortgage and the loan is fully repaid by the end of the mortgage term.

Q. Who might benefit from interest-only?

A: BTL investors focusing on short term cash flow management might prefer interest-only mortgages because they want to free up cashflow for other purposes. However, it is crucial to have a robust strategy for repaying the full loan amount at the end of the mortgage term. This might, for example, involve selling the property or other investments to generate sufficient proceeds after capital gains tax and selling costs to be able to repay the loan.  

Q. What are the risks of interest-only mortgages?

A: If you are relying on selling the property to repay the loan but the value of the property falls below the loan amount, you will need to find alternative sources of finance, such as selling some other investments perhaps, to meet the shortfall. Likewise, if you are relying on selling other investments to repay the loan but their value falls below the loan amount, you might also need to sell the property to meet the shortfall. On a different note, if mortgage interest rates rise dramatically, as they have done in recent years, the negative cashflow impact on those with interest-only mortgages can be harsher than on those with repayment mortgages, especially if the latter have been substantially paid down already. In some cases, such a situation might even force a BTL investor to consider selling their property prematurely.

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