Kryptonite On Twitter asks:
“Which is better for property investors… Interest only mortgages or repayment mortgages?”
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Q&A 50 – Repayment Or Interest Only Mortgage – Shownotes
Today’s question comes from Kryponite on Twitter:
Which is better for property investors… Interest only mortgages or repayment mortgage?
What’s The Difference Between Repayment And Interest Only Mortgages?
Thanks for your question Kryptonite. It’s a question that I personally have a definitive answer for whereas most in the personal finance space give an “it depends” answer.
Firstly, let’s define the difference between the two.
An interest only mortgage means that throughout the loan period, you only repay any interest that accrues on a monthly basis. Let’s make a nice easy example. You have a £200k mortgage @ 3% annual interest. Crudely, we can say that the interest is £6,000 a year, and hence £500 per month. Then at the end of the mortgage period (usually somewhere between 20 and 35 years in the UK), you will be liable to repaying the original mortgage amount (£200k) in this instance.
On the other hand, a repayment mortgage is structured so that you pay your interest every month, but you also pay down some of the original loan balance as well. This results in higher monthly payments, but at the end of the mortgage term, you will have a £0 balance left on the loan.
Which Is Better?
The traditional argument is that repayment mortgages tend to be better for people nearing retirement (as the liability will disappear as they approach retirement age), whereas interest only is better for younger investors.
Personally, I would argue that interest only mortgages are better for everyone.
First, let’s compare offers to see what interest rates are currently available for investors. To make a direct comparison, I’ve taken the £200k mortgage amount used before, with a house value of £300k (66.7% LTV), over 25 years, with an initial fixed period of 2 years.
The lowest interest only rate is a 2.25% tracker mortgage (available at three providers) followed by 2.29% at two other providers.
Using the same figures but for repayment mortgages show exactly the same results.
Therefore, there is no difference in interest rates. So, why do I favour interest only mortgages so much? Well, for two reasons: freedom & opportunity cost.
Benefits Of Interest Only Mortgages: Freedom
I’ll start with freedom because it’s the easiest to explain! The crux is that with an interest only mortgage you can repay the loan like a repayment mortgage if you wish. By this, I mean that you can make additional payments against the loan balance to reduce your mortgage capital at any time in the loan period.
However, with a repayment mortgage, there is usually not an option (or not at least a free option) to stop repaying the capital part of the mortgage and only make the interest payments.
Why is this useful? Well, in our example of the £200k mortgage, monthly payments on the interest only would be £375 per month. However, with the repayment mortgage, monthly payments are £872.26 per month in our example – a £500 a month difference. Therefore, having the freedom and control over your cash flow on a month-by-month basis can help in periods when you have voids or similar slow-downs in your inbound cash.
The exception to this is that in the initial period (2 years in this example), you are usually restricted to making 10% overpayments in the year. What does this mean for our example? Well, in our interest only mortgage option, it means that we could make overpayments in the first year of £20,000 and £18,000 in the second year. On a monthly basis, that would be £1,667 and £1,500 in year one and two respectively.
Therefore, as you can see from these figures, you can usually take out the interest only mortgage option as an investor and repay it like a repayment mortgage if you wish.
However, you probably wouldn’t want to. And that is because of the second, and slightly more complex reason: opportunity cost.
Benefits Of Interest Only Mortgages: Opportunity Cost
Time to do some maths and so I would recommend that you check out the show notes to see the calculations written down as that always helps.
Keeping with our same example as before, the investor would need a £100,000 deposit. Let’s imagine that we have that in cash, and then any repayment on the mortgage would come out of future earnings.
So, in the repayment example, we would take out the £200k mortgage and our figures after two years would look as follows:
Mortgage Balance: £187,714.06
Total Repayments: £20,934.24
Interest Paid: £8,648.30
Capital Repaid: £12,285.94
The equivalent for interest only mortgages would be:
Mortgage Balance: £200,000
Total Repayments: £9,000
Interest Paid: £9,000
Capital Repaid: £0.00
So, at first glance, it may look like we’ve saved £352 in interest and therefore repayment is better. However, this is where we need to compare to other investment opportunities: our “opportunity cost”.
You see, each month that you don’t make the extra payment of £497.26, we can be saving or investing that elsewhere. Because the interest rate we are saving is 2.25% in this example, that is what we need to earn with that money elsewhere to make the interest only mortgage option more profitable.
Let’s use an average figure of 10% that you would hope to earn from the markets. In those two years, that would return earn you a whopping £1,266 in positive returns. When compared to the £352 interest saved from before, this suddenly looks very appealing.
And, investors would hope to be earning more than 10% return from their properties and hence this number could be even higher.
We also need to add to this the impact of inflation. By keeping a higher loan balance (which interest only allows us to do), this debt is also effectively reduced by the impact of inflation. As a quick example, say you have a £200k debt today and your wage is £20k per year, then the repayment is 10 times your annual salary.
However, if your salary increases in line with inflation (say 3% per year as a long term average), then in 25 years’ time, you’ll be paid £41,876 per year and so the loan will only be 4.75 times your annual salary.
Repayment Or Interest Only Mortgages: A Conclusion
Therefore, in conclusion, I would recommend that investors always opt for interest only mortgages. Then, they can invest their money elsewhere when it makes sense to do so – obtaining greater leverage – and if it becomes financially beneficial to repay the loan (for example if interest rates soar), they can use the money that they’ve saved and invested elsewhere to pay down the loan when required.
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The key word here is investor. Providing the difference between the repayment amount and the interest only amount is used in a way to ensure the morgatage balance will eventually be paid off, you are good. The reason repayment can be better is some people will see the extra cash as income that can be put towards a new car payment plan or used for paying school fees etc. Every month is an exceptional month were they just need that cash. They are at risk of not paying the balance off.
Another argument for repayment is the return on the cash is guaranteed, whereas invested money is not. This could create a major headache if your investments don’t do as well as you hoped, esp at the time you most need them (e.g. No longer able to get a mortgage due to age when the interest only matures, just as 50% down turn in stocks hit).
Don’t get me wrong, the numbers really are impressive if you do get 10% and you do invest £500 a month at that rate. Total cost of repayment morgatage in the example at 2.25 over 25 years is ~£260k. £500 at 10% is ~£670k, remove £200k house balance and ~£110k of interest payments (total cost of interest only is £310k), profit is £360k! However, it should be noted that around 6% investment return is the ‘break even’ point in the above example (where you are no better off on interest only – £500 at 6% returns £340k over 25 years, so only £30k better off) and this relies on you being in a tax efficient account – otherwise break even would be higher.
The main point though is that whoever is asking this questions needs to understand their own temperament, life position and the return they expect to get based on their investment/risk profile (not sure I would confidently say 6% after tax personally).