Should I REALLY use an interest-only mortgage as a buy-to-let landlord?

I’m thinking about purchasing my first ever buy-to-let property. I know the city I want to buy it in and even have a couple of developments in mind.

The problem is, I’m unsure whether I should buy the flat with a repayment mortgage or an interest only mortgage.

The mortgage broker I spoke to said it was normal for landlords to buy with interest-only but that sounds rather reckless to me.

My question is, why do some buy-to-let investors prefer to buy with interest only mortgages? What are the advantages? Surely there is some sense in sticking with a repayment mortgage and paying down the debt.

Ed Magnus of This is Money replies: Interest only mortgages are very much the product of choice among buy-to-let landlords.

Since 2014, about 80 per cent of new buy to let mortgages has been on an interest only basis, according to UK Finance.

With an interest-only mortgage, you will only pay the interest each month, with the loan amount remaining the same.

This differs from a typical repayment mortgage where you will pay back a part of the loan, as well as the interest, each month until you eventually pay off the mortgage.

A core reason why investors opt for interest only, rather than a repayment mortgage is because it will help boost cashflow each month.

For example, a £200,000 mortgage being repaid over 20 years on a repayment mortgage at a rate of 5 per cent will cost £1,320 a month.

A £200,000 interest only mortgage on the same basis would cost £834 per month. 

The obvious drawback of interest-only is that you are not paying down the debt. 

This means that at the end of the 20 year term, the £200,000 mortgage will still need to be paid off, while with a capital repayment mortgage the property will be debt-free.

Mortgage lenders will want to know how a borrower plans to pay back the mortgage from the outset.

The most popular option for landlords is to pay off the mortgage off via the sale of the property itself, or another property.

We spoke to Rob Dix, co-founder of property advice website Property Hub and co-host of The Property Podcast and Howard Levy, director of buy-to-let lending at mortgage broker SPF Private Clients to ask for their advice. 

Why do landlords use interest-only mortgages? 

Rob Dix replies: It seems counterintuitive, but there are actually very few arguments for going with a repayment mortgage.

As an investor, your main risk is that you suffer a cashflow issue that means you can’t pay your mortgage and end up having the property repossessed – for example, if the tenant stops paying or you have unexpectedly high repair costs.

With a repayment mortgage, your monthly payments are higher because you’re paying both the interest and a proportion of the capital – so you have less profit each month that you can save up as a buffer.

The key point that people miss is that an interest-only mortgage doesn’t mean you can’t pay off the capital – just that you don’t have to do it on a set monthly schedule.

Expert: Rob Dix, co-founder of Property Hub, thinks interest only mortgages, if managed sensibly, are a better option for most buy-to-let investors

Most mortgage products will allow you to overpay by a certain amount each year and when you come to the end of a fixed term, you can pay off a chunk of capital then if you want to.

But even so, most investors are happy not to pay off the capital as they go along because over time the amount you’ve borrowed as a proportion of the property’s value will fall anyway.

That’s because as the years go on, the amount you borrowed will stay fixed, but you’d expect inflation to increase the value of your property.

Even if the property only goes up in value by an average of 3 per cent per year, after 20 years it will have not far off doubled.

It means, that if you started out by borrowing 70 per cent of its value, your debt would have fallen to around 40 per cent.

At this point you could either sell the property to easily pay off this remaining debt, or use a chunk of the rental income that you’ve been saving.

Using debt in this way is a big mindset shift, but it’s only ‘reckless’ if you stretch yourself too far in the first place or increase your borrowing as the value of your property rises.

Risky or sensible? Interest-only mortgages help to guarantee greater cashflow for mortgaged landlords, but at the expense of not repaying the debt

Pros and cons of an interest-only mortgage

Howard Levy replies: Much depends on your strategy: if you’re considering purchasing more than one buy-to-let, keeping some money back for the next deposit might be more sensible than using all your money to pay down debt on the first property.

The advantage of interest only is that you pay only the interest on your mortgage each month, keeping monthly payments down.

Landlords nearly always opted for interest-only mortgages in the past because mortgage interest could be deducted from rental income to reduce their tax bill, but this is no longer the case so it’s not such a clear-cut decision.

Expert:  Howard Levy, director of buy-to-let lending at mortgage broker SPF Private Clients says interest-only borrowers can typically repay 10% of the mortgage amount each year without incurring a penalty charge

With a repayment mortgage, you know that at the end of the term the property is yours so if it is affordable and fits with your strategy of ownership, then it is the safest option.

With an interest-only mortgage, on the other hand, you don’t pay any capital back and still owe it at the end of the term.

Many landlords sell their buy-to-lets, using the proceeds to pay back the mortgage, with hopefully a bit left over as profit, as they don’t need to hang onto the property in the same way as they would a main residence.

With any buy-to-let investment, it’s important to keep some money back to cover void periods, when the property isn’t rented out and you need to cover the mortgage that month.

You should also have a rainy-day fund to cover unexpected costs such as replacing the boiler or washing machine. If you don’t have much spare cash, it might make sense to build up this reserve fund, rather than opting for a repayment mortgage and making bigger payments each month.

We find that some clients prefer interest-only, but with many lenders offering a 10 per cent overpayment facility with no early repayment charges, another option is to build up funds and overpay as and when you can.

This has the same effect as taking out a repayment mortgage, as the extra payments reduce the capital, but you are not contractually obliged to make them, so it provides more flexibility.

Another consideration is whether you hold the property in a limited company or your own name. If the former and you reduce the capital, the amount of interest you can offset against the rent is also reduced.

Therefore, the ownership structure also plays a part in your question, along with whether you are a higher or basic-rate taxpayer. It’s important to seek mortgage advice from a whole-of-market broker, as well as speaking to a tax specialist.

> Do you have mortgage or buy to let question? ed.magnus@thisismoney.co.uk