Hi, Peter Jones, chartered surveyor, author and property investor.
And one of the big dilemmas and questions which I hear many property investors posing, particularly when they first come into property is ‘should I buy my properties using interest only mortgages or should I use capital repayment mortgages?’. And the received wisdom is that for most people it should be interest only.
Why is that? Well, for a number of reasons.
Firstly, because if you buy your properties with an interest only mortgage then your monthly cash flow is going to be greater.
The second reason is because behind the presumption that it’s the better way of buying investment properties, is the assumption that over time the value of the property is going to go up, whereas the amount that you’ve borrowed is going to be eroded by the rate of inflation. Let me give you an example of this. Let’s suppose you buy a property which is worth £100,000, and if values were to increase as they typically have in the UK over the last 50 years then values would double every 10 years.
Now, we could have a good debate as to whether that’s going to carry on into the future but just for the purposes of this illustration let’s assume that that is the case.
We know that if we buy the property for £100,000 today in 10 years time, chances are, it’s going to be worth £200,000. If we buy the property today using a 75% loan to value mortgage then we have a £75,000 mortgage and if it’s interest only, which means we literally just pay interest on the loan, but we never pay the capital down, in 10 years time we’ve still got a mortgage outstanding of £75,000.
But, of course the value of the property by that time has doubled from £100,000 to £200,000. So, as a proportion of the value of the property the loan is that much less. If we were then to go forward another 10 years then the value of the property would then be £400,000 in 20 years time. But, of course in 20 years time if we’ve had an interest only mortgage and the mortgage outstanding is still only £75,000. So, as a proportion of the value in 20 years time it’s obviously even less. But, in the meantime there’s been inflation.
At the moment the bank of England are charged with keeping inflation at around 2%, and when inflation falls below 2% their charged with increasing inflation so we often think about inflation as being a bad thing but it’s actually a good thing, it keeps the economy growing. Too much inflation is bad, not enough inflation is bad. There’s a sweet spot, and the bank of England are being told to keep it at 2%.
Well, let’s assume that inflation is 2% over the next 10 years, so in 10 years time we know our properties gone from £100,000 to £200,000, we still have a £75,000 mortgage on the property, but the effects of inflation are going to be biting away at the mortgage, which means in real terms the value of the mortgage is now down to, say, £50,000. If we then fast forward when the properties worth £400,000 in 20 years time, in real terms, in todays money, the value of that mortgage may only be £25,000.
So, we constantly have this differential which is moving *like that*, where the value of the property is going up but the real value of the mortgage is going down, and that gap is growing all the time which means that when we get to the end of the mortgage period then the real value of the mortgage as compared to the value in monetary terms of the property is that much less.
And that’s one of the reasons why investors use interest only mortgages, because they can increase their cash flow and they know that if they hold onto the property for long enough that the value of the mortgage itself is going to diminish which means that they don’t actually have to pay the mortgage down.
Peter
Peter Jones
(ex) Chartered Surveyor, author and property investor
https://www.ThePropertyTeacher.co.uk
PS. By the way, I’ve rewritten and updated my best-selling e-book, The Successful Property Investor’s Strategy Workshop, which is an account of how I put together my multi-property portfolio, starting from scratch and with no money of my own, and how you can do the same.
For more details please go to:
https://www.ThePropertyTeacher.co.uk/the-successful-property-investors-strategy-workshop