Plenty of investors still tie themselves in knots over which type of mortgage is “best”. Interest only or capital repayment?
Repayment feels safe and sensible. Interest only feels a bit riskier — but frees up cash.
So which is the right way?
Well, there is no right way as such. It all comes down to your goals.
Interest Only: Cash Flow King
With interest only, you literally just pay the interest each month. No capital repayment.
That means better cash flow and more rent is kept in your pocket each month.
But it also means that your loan never gets smaller, or paid off.
Initially, at least, this does not seem to matter because, unlike with residential mortgages, most buy-to-let lenders do not insist on knowing how you will repay the capital at the end. They just assume you will sort it out when the time comes.
Yes, the entire debt is still there when the mortgage term ends. But two things tend to work in your favour over 20 or 25 years, or whatever length of mortgage you opt for.
Number one, inflation eats debt. £75,000 today will not feel like £75,000 in 20 years’ time. Even at 2.5% inflation, the real value of that debt shrinks to about £45,000.
Number two, property values have tended to rise over the long term, though obviously not in a straight line and not by the same amount in every period.
So let’s run the numbers.
Say you buy at £100,000 with a 75% loan-to-value mortgage. You owe £75,000.
Twenty years later, if values have risen strongly over that period, your £100,000 property could be worth substantially more. The exact figure is not really the point. The principle is.
Your £75,000 loan may now be a much smaller percentage of the property’s value than it was at the start.
And in “today’s money”, that same £75,000 debt may feel much smaller as well, thanks to inflation. Assuming inflation averages around 2% to 2.5%, the real burden of the debt tends to reduce over time. In recent years, of course, inflation has not exactly behaved itself, which only reinforces the general point.
That is why many investors shrug at the idea of paying off capital each month and say words to the effect of, “What’s the big deal?”
And a quick tax note: with interest only, all your monthly payment is interest, so in a limited company structure it can all be offset against rental income. For property in your own name, it is less generous thanks to Section 24, but that is another debate.
Repayment: Slow and Steady
Repayment mortgages, on the other hand, bundle in both capital and interest.
So every month you chip away at the debt, and after 20 to 25 years the loan is gone.
That is comforting if you do not want to think about refinancing in future.
The catches?
You hand over more to the bank each month, so your cash flow is worse.
In the early years, most of your payment is interest anyway, so the capital reduction is tiny.
Yes, you are building equity each month — but it is your tenant’s rent doing that, not you. And if you are the type of investor who refinances to keep growing, you might just end up pulling that equity back out again anyway.
So, Which Is Better?
For portfolio builders, interest only usually wins. It maximises cash flow, keeps things flexible, and lets inflation do some of the heavy lifting on the debt.
For cautious types who want to sleep soundly knowing the mortgage is shrinking each month, repayment still has its place.
As always, it comes back to your goals. There is no one-size-fits-all answer.
With the luxury of hindsight, although I think that for me going interest only has made sense, I can also see that paying down mortgages on, say, every sixth property or even every tenth property might have made sense as well, just to ensure there was always some “emergency” capital available when it was needed, even during a property crash.
But that is not a strategy or investment model. It is just a muse by an older investor.
We all need to do what we think is right at the time, run the figures, weigh the risks and take the plunge.
And then, when we have done it, work to make it work — with no regrets or recriminations if it is not quite what we hoped for.
As ever, this is not advice. Don’t draw down loans or mortgages without taking advice from a good mortgage broker. If you don’t have a mortgage broker, or you’d like a second opinion, I’ll be happy to introduce you to mine. Just email me at thepropertyteacher@gmail.com and I’ll make the introduction.
Here’s to successful property investing.
Peter Jones
Author, property investor and ex-Chartered Surveyor
By the way, if you’d like a deeper dive into property investing based on the real-life experience of an investor who has built a substantial multi-property portfolio, my popular e-book, The Successful Property Investor’s Strategy Workshop, explains how I built my own portfolio from scratch and the principles that can help you do the same.
