A question I am quite often asked is, ‘should I still be buying my properties using interest only mortgages or has that all changed now because of section 24 and the tax changes?’.
Let me start by prefacing that with a quick comment. In the lending world the rules have changed slightly in that nowadays, if you were to apply for a residential mortgage, most residential mortgages are now capital repayment and you probably won’t have a choice, it’s going to be capital repayment.
But, in the buy to let world, most buy to let lenders are still doing interest only mortgages and will expecting you, as an investor, to take out an interest only mortgage.
But this doesn’t invalidate the question, should we be going interest only or capital repayment? This is often a big question and a big dilemma for property investors.
The argument is now, I’ve heard put forward, is that because of the tax changes with section 24, (section 24 says that if you own a property in your own name you can no longer offset mortgage interest against the rent when you’re calculating your income tax bill) there’s little advantage in having interest only mortgages so you may as well use capital repayment mortgages.
That might be the case if you’re buying investment property in your own name. But most investors nowadays are buying into a limited company. Why? Because at the time of writing, the section 24 rules do not apply to limited companies.
That means that if you have a limited company which holds property, the limited company can offset all of the mortgage interest against rent when the limited company is calculating corporation tax. So, within a limited company, it’s still tax efficient to have interest only mortgages.
Why else might we want to have an interest only mortgage?
Firstly, because it is better for cash-flow because you are only paying the interest, you’re not paying down the capital, so you pay out less and keep more rent.
Secondly, if you are going to periodically refinance your properties (which you probably are), if you’re a serious property investor, when the market rises, or perhaps you do a refurb and you add value to a property, there’s a good chance you’re going to refinance to withdraw equity to reinvest into your property portfolio.
So there’s little point in paying down the mortgage only to then refinance to get that money back out. To do that you’ll have to pay a valuer to go out to value the property, you will have to pay the bank their fees, and you’ll have to pay mortgage broker fees. Not to mention the legal fees associated with a refinance.
So wouldn’t it be easier, and cheaper, to have an interest only mortgage and to save the equivalent of capital repayments, so that money is in the bank waiting for when you need it?
Why would you want to refinance, or even better save? Because you can then use that money to go and buy more property. The money you take out could then become the deposit on more property, which will generate you even more cash-flow.
Another argument why interest only mortgages are a good way of financing property is because of the effects of inflation. The Bank of England are charged with making sure there is inflation in the economy, at least 2% worth of inflation. That’s what they are told they’re meant to create because deflation is worse than inflation. We need an inflationary economy.
As an aside many observers think the real rate of inflation is higher, despite what the CPI figures might say.
Over a period of time, if you hold your investment properties long enough, the nominal value of the properties will increase, whilst the relative value of the mortgages will decrease in money terms.
So, the gap between the actual value of the mortgage in real terms, and the value of the property in money terms, is going to increase over time because of the effects of inflation and because of the effects of house price inflation.
And at the end of the mortgage term, if you use interest only mortgages, the amount you owe on the mortgage in money terms will be the same amount as you borrowed at the beginning of the mortgage. But in real terms, it will be worth a lot less, and will be much less in relative terms to the value of the property (LTV). At that point you will understand why paying the mortgage down using a repayment product would have been a complete waste of time.
This is one of the reasons why some investors are somewhat relaxed about what happens at the end of the mortgage term and how they will pay the mortgage back.
If there has been strong inflation over the mortgage term then the amount owed in real terms will be significantly diminished and much easier to pay off.
Similarly, if the value of the loan in real terms has gone down while the nominal value of the property has gone up, the difference between the mortgage and the value of the property will increase (in other words, there’ll be more equity) which will make remortgaging much easier anyway.
When you take all of this into account, many investors are still of the view that interest only mortgages are best for them.
That’s not to say interest only would be right for everyone, there are no right and wrong answers. There might be circumstances where it makes sense to you to pay off a mortgage, but I think the circumstances are likely to be highly personal.
For most investors the answer is still interest only.
Peter Jones B.Sc FRICS
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