In my books, I advocate taking out interest only mortgages rather than repayment mortgages. I get a lot of emails from readers asking why: they think it's risky, or storing up problems for later.
And who knows, history might show them to be right. But there are a lot of misconceptions around interest only mortgages – and in this article I'll try to explain why I (and most other investors) choose to go down this route.
What's the difference?
The simplest way to look at it is this:
With an interest only mortgage, you're paying a monthly fee to rent money. At the end of the term, you need to pay the money back.
With repayment mortgage, you're paying a monthly fee to rent the money plus paying a chunk of the borrowed money back each month. At the end of the term, you owe nothing.
(If you want to get really geeky, this calculator shows how the proportion of interest and principal that makes up your monthly payments changes over the life of the loan.)
On the face of it, taking out repayment mortgages seems like the responsible thing to do: you know that as long as you make your payments, you own the asset free-and-clear at the end.
It's by no means a bad idea to do so. I just want to explain why I consider it a better option to go down the interest only route.
Why I'm a fan of interest only
In a word…cashflow.
With an interest only mortgage, the monthly payments are lower. Effectively, you're only paying one of the two components of a repayment mortgage: you're paying the fee to borrow the money, but not the extra component of paying off a bit of the capital each month.
Those lower payments are important, because the single biggest danger as an investor is the inability to pay your monthly costs. If you can't meet your outgoings, eventually the property will be repossessed by the lender – and when this happens, you'll lose the income stream plus all the money you put in as a deposit. Lower payments make it easier for you to make these payments, even if you have a period where the property is empty.
Also, the ability to borrow more
As well as loan-to-value, lenders look at rental cover when determining how much you can borrow. Criteria vary, but it's relatively typical to say that the rent must exceed 135% of the monthly mortgage payment at an interest rate of 5%.
To give an example, say you want to borrow £75,000. The monthly interest payment at a notional interest rate of 5% would be £312.50. Your rent would therefore need to be at least 135% of £312.50, which is £422.00.
With a repayment mortgage, your monthly repayment would be £438.44 rather than £312.50. That means your rent would need to exceed 135% of £438.44, which is £591.90.
If your rent wasn't that high, it means you couldn't borrow that much – so you'd have to put in more of your own money to but a property of equivalent value (thus reducing your ROI).
This is the real killer argument in favour of interest only: it doesn't mean you can't pay off the capital.
To continue our example from earlier, say you opt for an interest only payment of £312.50 rather than an interest + capital payment of £438.44. That means that every month, you end up with £125.94 more than you would otherwise have done.
At the end of a 2-year fixed rate period, you've got £3,022.56 extra in the bank. You can now decide to leave it where it is, put it towards the deposit on another property…or pay a lump of £3,000 off your mortgage balance in one go.
Paying off a lump of capital would put you in the same position as you would have been if you'd had a repayment mortgage all along…but with the benefit of lower monthly commitments and more options.
Many people will disagree with me, and that's fine – if you feel that capital repayment makes the most sense for your situation, then there's no reason why you have to do the same as me.
I've heard a lot of objections to the idea of interest only, of which the most common are…
What will I do in 25 years when I need to repay?
First of all, the typical term of any given mortgage is 25 years – but there's nothing to stop you from refinancing to get a new 25 year term at any point.
In other words, taking out a mortgage today doesn't start a 25-year clock ticking, at the end of which you need to stump up the cash to give the lender their money back.
There are limits: you'll struggle to get a mortgage once you're into your 70s, and you might decide you don't want mortgages hanging over you once you're beyond a certain age anyway. But the point is that 25 years isn't a hard limit.
Won't I have to sell the house to repay the loan at the end?
Yes, if you haven't made any other plans to repay. But you've got lots of time to make other plans – and by the time you have to repay, inflation should have helped you out.
For example, according to this inflation calculator, £100,000 in 1990 was worth £224,000 in 2015. That means if you took out a mortgage for £75,000 to buy a house worth £100,000 in 1990, that house today would be worth £224,000 – but your £75,000 debt would still be £75,000. Your loan-to-value would have more than halved, from 75% to 33%.
(Average annual inflation during this period is 2.9%, and in the future it could of course be lower – or negative. But remember that we're not factoring in any additional house price inflation at all.)
This opens up options like just selling one or two of your properties to pay off the mortgages on all the others.
What if the property is worth less than the mortgage at the end?
Over a 25 year period, this is exceptionally unlikely. If it went up in line with RPI inflation it would be worth 122% more today than in 1990. Even if you took annual inflation to be 2%, it would still be worth 64% more than you paid for it. For it to fall in value over 25 years, property prices would have to crater in an absolutely dramatically enormous way compared to the general economy.
In parts of the country, that's unlikely but not impossible. Even so, you need to think about what your maximum possible downside is. Say the property falls in value from £100,000 to £80,000 over the course of 25 years. You can still repay at the end – you'll just have lost the deposit you put in at the start.
What if interest rates go up?
In this case, I'd say you'll be even more glad to be on interest only. Going back to our example earlier, at an interest rate of 9% rather than 5%, your interest only payment would be £562.50 and with capital it would be £629.40. At the higher payment, it's going to be even harder for you to make your monthly payments – which can mean repossession if you can't.
What if the property falls in value?
Even though it's very unlikely that property will be worth less in 25 years than it was at the start, it's very possible that it will be worth less in 5 years.
In this scenario, you might not be able to remortgage and your lender might ask for more collateral. If you've been paying off the capital, your mortgage balance will be lower so this is less likely to be a problem.
However, as the geeky calculator shows, the payments start by being geared towards interest and the balance only shifts to paying off capital later. Over the first 5 years of our example loan, you've only paid off £7,000-worth of capital – which isn't enough to make an enormous difference.
And remember – if you've kept that £7,000 in the bank, you can always just pay off a chunk of capital in one go anyway.
Again, there's no reason in the world why you shouldn't take out a capital repayment mortgage if you want to. You might decide that the certainty of owning the property outright in 25 years is the most important factor to you, and there's nothing wrong with that at all.
I just wanted to show that going down the interest only route isn't as irresponsible as it first appears – and most of the common objections have pretty solid answers.
Of course, when we're talking about the future, nobody has the slightest clue what's actually going to happen – it's all about looking at the balance of probabilities. So let's catch up in 2041 and see how we all got on…