MORTGAGES – Interest Only or Capital Repayment?

MORTGAGES – Interest Only or Capital Repayment?

13:55 PM, 30th June 2022, About 2 months ago 29

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My personal view is that an interest only mortgage is far better than a capital repayment mortgage, here’s why …

Back in 1971 my parents borrowed three times their joint income to buy a house that cost them £3,000. Yes you read that right, THREE THOUSAND POUNDS, and that bought them a three-bed house in South Staffordshire.

They put down a 10% deposit and took on a mortgage for the balance of £2,700. It was a real stretch for them because mortgage interest rate were five times higher than they are now.

Their bank manager persuaded them with financial logic they they would be far better off having a 15 year repayment mortgage, so that’s what they did, despite crippling their household cashflow. It was a Bank Manager’s financial logic, NOT the financial logic of an entrepreneur.

Now let’s fast forward to 2022, the house is now worth £300,000. If they had taken an interest only mortgage of £2,700 their monthly repayments today, assuming say a 2% interest rate, would be just £4.50 a month.

Was it really worth crippling their cashflow all those years ago, forsaking holidays and “making do”?

What if they had taken interest only mortgages and remortgaged their property, say every 10 years, and used the funds as deposits to buy more properties to rent out? Might they be multi-millionaires by now? I think they might well have been,

However, life never really turns out exactly as you planned does it? The reality was that after 10 years my parents took on a second mortgage to pay for double glazing, a new front door and to build a garage. A few years after that they sold their property and purchased a much bigger and more expensive one, again with a much bigger mortgage. They were always on the verge of being broke as a result of the advice their bank manager had given to them.

On the other hand, my brother and I did things very differently. We always took interest only mortgages and refinanced as much equity out of the properties as we could, to serve as deposits to buy more properties. However, we didn’t take big risks (in our opinion) because we also hoarded the cash we would have been paying if we have taken 15 year repayment mortgages. Our thought process was very simple; if we needed cash we had repaid on our mortgages we would be at the mercy of the banks to lend it to us. However, if we had the cash we were in control of our own destiny.

This strategy worked out well for us both, because life always throws you a ‘curve ball’ every so often. Sometime interest rates went up, tenants stopped paying rent, properties were vacant and producing no rent, unexpected maintenance issues occurred and a few properties got trashed. It didn’t hurt us too much though, because we had cash in the bank to deal with these scenarios.

Also consider that as property values fall it gets harder to borrow. When dealing with a crisis position, e.g. a desperate need for cash or unaffordable mortgage payments, would you prefer to have a slightly smaller mortgage or extra cash in the bank?

Why repay low interest rate debt and then borrow back at higher margins when you need cash?  Property Investment involves positive cashflow and management of liquidity.  In my opinion, there is no sensible argument for making capital repayments on the mortgage, especially if you are still expanding your portfolio or may need to access funding for other purposes.

My Property Investment Strategy

The beginning of my career was spent working in financial rescue and the underwriting of risk.  It was the late 1980’s, property values had plummeted and interest rates had soared to 15%.

Property investors who faced financial ruin at that time all had one thing in common, and it wasn’t what you might think.  It wasn’t high gearing, despite the crash in property values, it was a shortage of cash.  Investors with high gearing and high liquidity (cash in the bank) fared well.  This taught me that “Cash is King” and that equity left in property is subject to high risk.

Why I believe property investment makes so much sense

Vast quantities of people choose not to own their own home for a variety of reasons and prefer to pay rent for the privilege of occupying property.  In fact, in the early 1900’s over 90% of people in the UK lived in rented accommodation.  This fell to a low point in 1973 to just 7% of the population.

The basics

I use rental income to service mortgages and the management, maintenance and insurance expenses associated with property ownership.  Over time, inflation and other factors increase the value of my properties and the rent.  However, my mortgage balances remain constant, assuming of course that only interest is paid.  Therefore, as the years roll on the gap widens between the rents received and the total outgoings thus creating an improved cash flow position.  Rising property values also increase my net worth.  A strategy of borrowing ‘cheap money’ to purchase property is, therefore, an effective method of accelerating my wealth by using other peoples’ money.

Why I released equity whenever a realistic opportunity to do so presented itself, especially during my first two decades in this business

It’s all about transfer of risk.  If equity is left in the property and the property reduces in value the equity may no longer be accessible and I am taking all the risk.  However, once the property is refinanced, I control the liquidity and the risk is transferred to my lenders for which they earn premium interest returns.

The following simple example might explain this better.

Let’s assume I own an investment property worth £100,000 with no mortgage.

One morning I wake up, turn on the TV and watch the news which announces that property values have fallen by 50%.

My property is now worth £50,000.

Prior to this happening I could have raised a mortgage of £75,000 and kept the money in the bank.  I would then have a property worth £50,000 and a mortgage of £75,000.  Therefore I would have £25,000 of negative equity!

Would I be at risk though? Remember, I would still have £75,000 in the bank.

So what are my choices?

I could feel sorry for the bank.  After all, the bank are now carrying the risk.  If this is the case I could repay the mortgage, or,

I could simply keep the money in the bank, or

I could use part of the money to buy more cheap properties and keep some on one side for a rainy day.

If I had not refinanced I might well find it difficult to raise money as the banks would be nervous about lending at this point.  If I then decided to get funding I would probably pay more for it.  Additionally, if I could then borrow 75% of the value of my property, I would only manage to raise £37,500.

If the market goes the other way and property values increase then another window of opportunity may well open to release even more equity.

What are your thoughts?



Comments

Trevormlazenbury@aol.co.uk

8:36 AM, 1st July 2022, About 2 months ago

I concur with your thoughts about interest only and not capital repayment mortgages.
Furthermore most lenders permit up 10% capital repayments each year without triggering a penalty. So for those that want to have a nibble they should be able to do so ...... and if the mortgage is say £100,000 that should permit a capital repayment of £10,000 pa.
Taking care that:
• if there was a drop in the property market, that the property investor is not too highly geared so that with the wobble they now are in breach of some of the lenders covenants.
• the time that the mortgage needs to be repaid is a long way off. If there is not succession planning and the mortgage needs to be paid off in say 5 years the borrowers should look to take out mortgages over the maximum period that they can, whilst they are young enough to do so ........................and buy some more!!
There will also be the IHT relief on the debt left behind and hopefully the investors would have enjoyed spending some of the money, what would have been the capital repayments, on themselves and their families.

Gwen Davies

8:50 AM, 1st July 2022, About 2 months ago

What excellent advice. I do wish I’d heard this at the start of my property journey. I think I did it the wrong way. Hopefully I’ll be able to get out now with a profit. But thank you Mark for this site and your help through the years. I think I asked you once why you called it 118. I can’t remember what your answer was and certainly not what I was thinking. But, as a coincidence psalm 118 v 8 is the very centre of the Bible. Maybe without knowing it you were inspired! 😂 Thank you and every good wish for your future.

JohnCaversham

9:13 AM, 1st July 2022, About 2 months ago

Absolutely agreed, I had the same conversions with my parents more recently. Back in 1967 I was the youngest of 5, so the family moved to a larger £2.7k 5bed detached in Caversham Berks, back then bigger properties were often seen as a liability especially one that was tired even by 1960's standards. Anyway dad was a grafter, self employed carpet fitter, and I think the stress and hard work of paying off a huge mortgage and raising 5 children took it's toll on mum and dad, no treats for them in the early days, mum keeping a daily written log of everything they spent, bus fares the lot... The mortgage was finally paid 25yrs later in the early 90's when the house was probably worth £300k, now in 2022 it would be around £1.1m....When I first invested in property in the 1990's I remember telling dad that year on year their property had increased in value by more than he had earned each year working himself half to death! On the day of the final mortgage payment he could have put the whole original £2.7k purchase price on a credit card! My main res is cap/int, while our btl's are int only with regular re-gearing and re-investment, allowing us to undertake building projects to create an additional income stream.

geester24

9:37 AM, 1st July 2022, About 2 months ago

I’d be interested to know what people’s thoughts are on this as one gets older.
So mortgages held are all interest only and have term limits which end when one is 70. Do you think mortgage companies will adjust and these be extended to 80 or lifetime. it seems a waste to pay these off rather than reduce IHT. Better to enjoy the money or pay for care costs than pay off a BTL mortgage as the loan to value generally reduces and inflation erodes the debt.
Should one ever pay off a BTL mortgage?

NewYorkie View Profile

9:42 AM, 1st July 2022, About 2 months ago

Thank you, Mark, for highlighting this.

IO has got a bad rap over recent years, and you do need a clear strategy for repaying those mortgages. But Repayment mortgages caused so many problems at the end of the 80s, when friends of mine were over-extended, and as you point out, crucially they did not have access to cash for those rainy days because they were paying high mortgages on negative equity.

To me, the logic is spot on, and apart from my resi mortgages, I've always used IO for rental property. I took out significant equity in the rising London market [and now sold up], and have never made ad-hoc repayments, preferring to have the cash.

I am currently exiting the PRS. Not because of affordability [although I was badly affected during the pandemic], but because I've retired, and have better things I want to do with whatever time I have left, rather than worrying about providing housing in an increasingly hostile environment.

Mark Alexander - Founder of Property118 View Profile

9:46 AM, 1st July 2022, About 2 months ago

Reply to the comment left by geester24 at 01/07/2022 - 09:37
We will be releasing a video at 5pm on Monday to answer this question. As a “heads up” though, it’s easy to get a 30 year BTL mortgage at the age of 74 and there are many more options explained in the video

Gwen Davies

10:08 AM, 1st July 2022, About 2 months ago

Reply to the comment left by Mark Alexander - Founder of Property118 at 01/07/2022 - 09:46
Thank you. That sounds interesting

JB

11:13 AM, 1st July 2022, About 2 months ago

I would only take IO mortgages. As someone said you can pay a bit off each year if you wish or the whole lot when you're past the early repyament charges.

I've paid off some mortgages recently with the aim of taking out higher LTV's on fewer properties at a fixed rate for 5 years. Although the interest rate is a bit higher for higher LTV's if you can keep a property or two mortgage free it gives the option of mortgaging them at a later date if you want/need cash. We used to draw down but I dont think that option's available now and in any case it wouldn't be available if prices drop.

I'm only taking out 5 year mortgages on properties with an EPC of C or above in the hope that that will be sufficient for when the new EPC regs come in.

Ian Narbeth View Profile

11:35 AM, 1st July 2022, About 2 months ago

Hi Mark
Can you also add a bit about dealing with the CGT trap? With an investment property, CGT will be payable when the property is sold. If you release equity by borrowing a high percentage of the increased value you may end up with insufficient to pay both the tax and the debt.
E.g.
Purchase Price £100,000
Sale Price £500,000
Gain £400,000
Tax @28% £112,000
Debt @80% £400,000
Net (£500,000-£400,000 - £112,000) = minus £12,000

Rod

12:21 PM, 1st July 2022, About 2 months ago

Governments have always relied on inflation to erode the relative cost of capital repayment.

Like any market, there will be dips as well as peaks, so Mark's strategy of keeping at least some of the outstanding debt in cash or savings allows us to ride out the dips.
This savings pot will also help avoid Ian's CGT trap scenario. Don't forget, we now need to pay CGT within 2 months of sale.

Provided you have a trustworthy, competent agent or a family member willing to take over management, any gains will be disregarded on death with net assets subject to IHT (subject to primary residence exemption). Savings are, after all, supposed to be deferred spending so keep paying the interest, allowing you to dine and holiday like a banker.

Before you head off on that holiday, don't forget to put the basics in place:

- current schedule of assets and liabilities
- tax and estate planning
- up-to-date will
- lasting power of attorney

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