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

I am thinking of buying my first rental property. I know the city where I want to buy it and I even have a couple of new things in mind.

The problem is that I’m not sure if I should buy the apartment with an amortization mortgage or with an interest-only mortgage.

The mortgage broker I spoke to said it was normal for homeowners to buy with interest only, but that seems pretty reckless to me.

My question is, why do some buy-to-let investors prefer to buy interest-only mortgages? What are the advantages? Surely it makes some sense to continue with a repayment mortgage and pay off the debt.

Ed Magnus from This is Money responds: Interest-only mortgages are largely the preferred product among buy-to-let homeowners.

Since 2014, around 80 per cent of new buy-to-let mortgages have been interest-only, according to UK Finance.

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

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

A key reason investors opt for interest-only, rather than a repayment mortgage, is because it will help boost cash flow each month.

For example, a £200,000 mortgage repaid over 20 years with an amortizing 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 a month.

The obvious drawback to paying interest only is that you don’t pay off the debt.

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

Mortgage lenders will want to know from the beginning how the borrower plans to pay the mortgage.

The most popular option for homeowners is to pay off the mortgage by selling the property itself or another property.

we spoke with Rob Dixco-founder of property advice website Property Hub and co-host of The Property Podcast and Howard Levybuy-to-let lending director at mortgage broker SPF Private Clients for advice.

Why do homeowners use interest-only mortgages?

Rob Dix responds: It seems contradictory, but in reality there are very few arguments to opt for a mortgage with amortization.

As an investor, your main risk is suffering from a cash flow problem that means you can’t pay your mortgage and end up repossessing the property, 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 are paying both the interest and a proportion of the principal, so you have less earnings each month that you can save as a reserve.

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

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

Most mortgage products will allow you to overpay a certain amount each year and, when you reach the end of a fixed term, you can pay back some of the principal if you wish.

But even so, most investors are happy not to pay down the principal as they go because, over time, the amount they have borrowed as a proportion of the property’s value will decrease anyway.

This is because as the years go by, the amount you borrowed will remain fixed, but inflation can be expected to increase the value of your property.

Even if property value only increases on average 3 percent a year, after 20 years it will not have doubled.

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

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

Using debt in this way is a big mindset shift, but it’s only “unwise” if you try too hard in the first place or increase your debt as your property value increases.

Risky or sensible? Interest-only mortgages help ensure greater cash flow for mortgaged homeowners, but at the cost of not paying the debt

Pros and cons of an interest-only mortgage

Howard Levy responds: A lot depends on your strategy: if you’re considering buying more than one rental property, keeping some money for the next deposit may make more sense than using all your money to pay off the debt on the first property.

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

In the past, homeowners almost always opted for interest-only mortgages 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, head of buy-to-let lending at mortgage broker SPF Private Clients, says interest-only borrowers can usually pay 10% of the mortgage amount each year without incurring a penalty.

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

On the other hand, with an interest-only mortgage, no principal is repaid and is still owed at the end of the term.

Many homeowners sell their rental homes and use the proceeds to pay off the mortgage, hopefully leaving a bit of profit left over since they don’t need to hold on to the property in the same way they would a primary residence.

With any buy-to-let investment, it is important to keep some money aside to cover the void periods, when the property is not rented and you need to cover the mortgage that month.

You should also have an emergency fund to cover unexpected costs, such as replacing your boiler or washing machine. If you don’t have a lot of extra money, it might make sense to build up this reserve fund, rather than opting for a paydown mortgage and making larger payments each month.

We find that some customers prefer to pay interest only, but as many lenders offer a 10 per cent overpayment facility with no early repayment charges, another option is to accumulate funds and overpay where possible.

This has the same effect as taking out an amortizing mortgage, as the additional payments reduce the principal, but you are not contractually obligated to make them, so it provides more flexibility.

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

So ownership structure also plays into your question, in addition to whether you are a higher or more basic rate taxpayer. It is important to seek mortgage advice from a broker across the market, as well as speak to a tax specialist.

> Do you have any questions about a mortgage or buy-to-let? ed.magnus@thisismoney.co.uk

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