MORTGAGES – Interest Only or Capital Repayment?

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?

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