Repayment or interest-only?

April 05

This has to rank as one of the questions I am asked most - should a landlord finance their investment property using a repayment mortage, an interest only mortgage, or a flexible mortgage.

Which you choose will depend on your personal circumstances, your timescale for investment, and your exit strategy, and it is an area where professional advice is certainly needed. I am not a Financial Advisor, and strongly recommend that you go and see one before buying any mortgage.

However, it is worth noting that the majority of professional investors choose interest only loans for their investment properties for a number of reasons.

Let us start by a quick review of the two basic types of loan.

An interest-only loan is where the lender charges interest on your borrowings, and you make a monthly payment to cover that interest but no more. If you have borrowed £100,000 and paying interest at 6%, then your payments will be £6,000 a year, or £500 a month. At the end of 25 years, you will still owe the lender the full £100,000.

A repayment loan is where the lender charges interest on your borrowings, and you make a monthly payment to cover that interest plus pay back part of the borrowings. These payments are normally arranged to be constant over the period of the loan. The balance, however, gradually reduces, so in the first few years, most of the monthly payment is covering the mortgage, with only a little capital paid off, wheras towards the end there is relatively little interest, and more capital paid off. The good news is that, at the end of 25 years, our borrower would have paid off all of his or her £100,000. However, instead of paying £500 per month, they would have been paying £650.

This brings us to advantage number 1 of the interest-only loan. In the early years of a property investment, cash-flow is typically tight. The extra £150 a month in the investors bank account may be utterly critical.

Advantage number 2 of the interest-only loan is the way that tax is calculated. One of the things that you can offset against rent is the interest paid on your loan. You cannot offset the capital- repayment part of the mortgage. The trouble with a repayment loan is that the amount of interest you pay is gradually reducing. In our example above, our borrower, in year 10 (assuming no refinancing) would be paying over £1,250 less in interest, so (for a higher rate taxpayer) would be paying over £500 more in tax. The effect of this tax on cashflow would mean that instead of having £150 less each month, they had £190 less each month.

For these two reasons, cash-flow, and taxation, most landlords choose to finance their properties with interest-only loans.

However, the question still remains - how will this interest-only borrower come up with the cash to pay off the full balance in 25 years time. This is where it is important to consider exit strategies right at the beginning. There are a number of possibilities.

Firstly,the landlord might simply decide to sell up at that point. What will our property, worth £100,000 in 2005, be worth in 2030? It is impossible to predict, however, consider that, 25 years ago, a three bedroom house near me might have cost £10,000. The same house might now be worth £200,000. Of course, no-one is predicting that inflation will go back up to the levels we had in the 80s, but equally, it is hard to believe that it will consistently stay at about 1-3 per cent for the next 25 years. Assuming that the £100,000 property only doubled in value over 25 years, then there would be a capital gain of £100,000, so a capital gains tax liability of between 15-30k depending on whether there were single or joint owners, and whether they had already used their CGT allowances in the year of sale (and assuming that they had held it long enough to qualify for taper relief.) Even after paying this, the proceeds from the sale would still give between 170-185k, which would pay off the 100k borrowing, leaving 70-85k in cash.

Secondly, at some point between now at 2030, the landlord might decide that the market was high and decide to sell out to take advantage of such a peak. It is impossible to predict now when such a peak might come, but it is not outside the bounds of possibility to imagine that, say, there might be a 2024 housing boom, which pushed the property up to £300,000, before falling back to £200,000 by 2030.

Thirdly, and most likely, at some point between now and 2030, our landlord will re-finance the property to take out more cash to use as a deposit on their next investment. At that point, the 25 year clock will start again, and the problem will be deferred.

Now, let us come back to flexible loans, and see whether they might have a place in the life of the landlord.

A flexible loan is a special type of repayment loan, with some extra features, which may or may not be useful. The general idea is that the lender calculates the interest on a daily basis rather than a yearly basis, and allows overpayments with drawdown. This is to say that, if our borrower is feeling flush in February, they can overpay by £100, and do the same throughout the year until November, by which time they will have overpaid £1,000. Then Christmas comes and they draw back that £1,000 to buy themselves a plasma telly. The advantage of this overpayment compared to simply stuffing the money into a deposit account is twofold. Firstly, while the deposit account might pay them 2-3% on their money, the overpayment on the mortgage loan would save them 6%. Secondly, if you earn interest, you pay tax on that interest. If you save interest by overpaying, then there is no particular tax to pay simply because you have not paid as much interest as you would have done otherwise!

For these two reasons, for those who are in a position to make regular overpayments, flexible mortgages have become popular.

However, for the landlord, there is a further wrinkle to do with tax.

Now, remember I am not an accountant, and this is my understanding - but if you overpay on an investment loan, and subsequently withdraw the money to buy the aforementioned plasma telly, then the Inland Revenue can say that this withdrawal is a NEW borrowing, and that the investment loan had been PERMANENTLY reduced by the amount of the overpayment. Thus, the interest that you can offset against tax is permanently reduced. This is both incredibly difficult to calculate and potentially an area that could waste a lot of time arguing with the revenue.

So, it might seem like the disadvantages of a flexible loan outweight the advantages the landlord. Well, yes, and no. I have certainly taken the view that, for my investment loans, I have standard interest- only loans.

However, on my PPR, I have a flexible loan. That means that, when I am saving for a deposit, I can earn (save!) the higher rather of interest that the mortgage company charges me for my house, and do so tax free, but write a cheque out of that account whenever I buy a property or pay a tax bill. While most people in paid jobs have a relatively constant cashflow, maybe affected by summer holidays and Christmas, the property investor can have many tens of thousands of pounds come in for a few months, before being spent again. For example, if I sold a property now, I would know how much capital gains tax would become due next January, and use the flexible loan as a place to store the cash needed for that tax bill. Alternatively, if I sold a property at the end of April, the tax bill would only sort itself out in January 2007. Having a tax-efficient, interest-bearing (saving!) place to store that cash for 20 months is a low-risk alternative to re-investing in a short-term project.

This is just the feature article from the April 05 newsletter. Subscribe for market comment, forthcoming events, and more.

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