In it’s most basic form this mistake manifests as not shopping around for the best LTV (loan to value ratio) or the best interest rate (½% over 20 years makes a lot of difference) or finding the loan with the least penalties if you want to swop or pay it off early.
A more sophisticated investor will also consider whether to opt for a repayment loan or an interest only loan. There are benefits and disadvantages with both.
The positives of opting for an interest only loan are:
You literally only pay the interest on the loan. Unlike a standard residential mortgage, where lenders require the loan to be backed by an endowment policy or some other means of paying the capital element at the end of the term, some Buy-to-Let lenders don’t need to know how you intend to repay the loan. They just take in on trust that at the end of the term, you will repay the capital. This means that your cash flow is even greater; there’s no payment towards the capital or to an associated savings scheme, and so you get to keep more of the rent.
Of course, you will still have to pay the loan back at the end of the term – we’ll talk about that in a minute.
- As things currently stand now, you are allowed to offset interest on your loan for tax purposes. As your entire payment is interest, the whole payment can be offset against income for tax purposes every month.
By contrast the principle benefit of a capital repayment mortgage is:
- As each monthly payment is made up of interest, plus a contribution towards the capital element of the loan, over time you will gradually pay off the loan. At the end of the term there is no more to pay. So with each repayment, you are increasing your equity in the property; in other words, your net worth increases with every payment.
Of course, this leads to one obvious and one not so obvious disadvantage:
- Because the monthly payment includes capital as well as interest, you pay more to the bank each month than if you were just paying interest. So your net cash flow each month will be reduced, and you get to keep less of the rent whilst the bank gets to keep more.
- At the beginning of the term most of the monthly payment is interest, so in the early years a large proportion of the monthly payments can still be offset for tax purposes. However, during the loan period the proportion of capital paid against income increases, until towards the end of the loan you will be paying more capital than interest. This means that as time goes on, you’ll be able to offset less and less interest against income and so your tax liability will increase*
The key question is “which type of loan is best for investors?” There are two views on this:
Firstly, there is perceived security from paying down the loan with a capital repayment mortgage. Every month you owe less and are worth more. At the end of the loan period you own a totally unencumbered property.
But is this realistic? If you think about it, paying off the loan doesn’t make a lot of sense. If you are a serious investor you will be regularly refinancing your properties as capital values rise, and use the money drawn down as deposits for your next purchases. What is the point of paying capital back to the bank, only to take it back out again a few months later, and incur the costs of refinancing? You would be better off keeping the money in your bank account where you can access it easily and quickly when you need it.
Secondly, the diminishing ability to offset interest against income is significant in the last few years of the loan period; so much so that some ‘experts’ say this is reason enough for opting for interest only loans.
If you, like me when I first heard this argument, are wondering what how you will repay the capital at the end of the loan period, ‘the pro interest only lobby’ argue it this way.
Remember that on average UK house prices have increased by 8% per cent per annum over the last 40 years. So if you were to buy, say, a property worth £100,000 with a Buy-to Let loan of 85% LTV, you’d owe £85,000 (I’ve kept the example simple by ignoring bank, legal and valuation fees). If this is an interest only loan for 20 years, at the end of 20 years you will still owe £85,000. The point is though, that during the same period property values will have increased (hopefully) by an average of 8% per annum and your property will now be worth £466,000. Now the loan, as a proportion of the value, will be only just over 18%.
And that’s not the end of it because, at the same time, something else will have been working in your favour – inflation. The Bank of England are currently charged with keeping inflation at 2.5% or less. Whether they can achieve this in the long-run, only time will tell, but let’s assume they can over the next 20 years. Even at 2.5% per annum the real value, or buying power, of your pound will be reduced by an equivalent amount. This is the opposite of compounding. It means that at the end of 20 years the loan of £85,000 will be worth only £51,872 in today’s spending terms.
Looked at this way, they argue, will you really care about the loan in 20 years time? If you want to pay it off the sale of just one property from your, by then, extensive portfolio may clear all or most of your outstanding loans.
So which way is best? Well, I still think that depends on you and what you are trying to achieve. For the more adventurous interest only loans might be better. For those of us who are a bit more timid, there is some security in knowing that each month you owe less against your existing properties and so a combination of the two may be appropriate; split the portfolio between say, high yielding, low value properties on capital repayment loans and high value, low yielding properties on interest only loans.
The solution? As always it comes back to goal setting. When you set your goals think through which financing package bet fits what you are trying to achieve. If you already have property, think about switching either the type of loan, or the lender, or both, until you have the combination and terms that are best for you. If you aren’t sure what you need, consider using a good mortgage broker, they can be well worth their fee.