Interest only or repayment mortgages are getting you stuck? Here’s how the NC Real Estates Members Clubs accountant Craig Hopkins thinks about it.
Want to contact Craig directly: email@example.com / 0118 377 7992
INTEREST ONLY vs CAPITAL REPAYMENT MORTGAGES – THE DEBATE
Like all posts, this is just my thoughts, philosophy and opinion. It is not financial advice and if you old enough to read this, you old enough to judge it for yourself. Don’t believe everything you read on-line as I think a lot of the free advice people give – they overcharge for given the quality of it! Just my opinion!
Before even looking at BTL, let’s look at your own home….
Jack and Jill are identical in almost every way. Bought houses next door to each other and paid the same £100k and took out he same £80k mortgage. They work for the same company and earn the same. Eat the same breakfast, and so on.
The only difference is Jack has an interest and capital repayment mortgage on his home. Jill does not but pays the same amount each month. The difference between her actual mortgage cost and the payment she actually makes goes into a liquid savings/investment account.
Sadly they both worked for a company that one day went bust.
Jack had paid down his mortgage to £65k at the time of being of being made redundant and the property had gone up to £130k in value. He was very focused on this and was trying to pay it off quickly and he feels like a rock star! He was at 50% LTV. Despite being made redundant, the bank still wanted their regular interest and capital repayment each month. He was unable to tap into the equity because the bank lends him money on the strength of his earnings. The property is merely a security. Without earnings, it is a short conversation with the bank! With this financial pressures mounting and no savings, Jack took the first crappy job that came his way and ended up with some missed payments and penalty letters from the bank for late payment. These will stick around on his credit report for the next 6 years!
Jill on the other hand also had a property worth £130k. Her mortgage was still £80k. Like jack she is unable to remortgage without a job or income. She does however have £15k in savings (the same as the amount Jack had reduced his mortgage by). The bank also want the regular monthly payment – but it is a lower amount being just the interest. They don’t expect or want capital. This puts her under less pressure than Jack. Yes she eats into her savings looking for the right job and eventually finds a great new job that pays more than Jack. She has not missed payments or bad credit – just a little less in savings than she would like. With her new job she goes back to saving like she used to.
Hansel and Gretel each have a BTL portfolio of 10 properties. They are identical terraced houses all worth £100k each with £75k mortgages on and all on the same mortgage product with the same bank. The only difference Hansel is on capital repayment on all mortgages and Gretel is on interest only. Hansel is trying to buy the right hand side of the street and Gretel the left. Did you know if you own all the houses in a street you can get it renamed? They plan to call it “Candy lane”.
Over time Hansel has managed to pay off £5k on each of his 10 mortgages for a £50k reduction in his overall debt. He feels like a rock star!
Gretel also paid off £50k but she discriminated against one property – chosen at random as they are all alike. She has 9 properties with 75% LTV / £75k mortgages. One property has a £25k or 25% LTV balance outstanding.
A landlord with a 2 properties in the street – one on the right and one on the left He calls the twins as he is looking to sell his two properties at £100k each. They just need to come up with £25k each for the deposit and their quest to own the street gets a bit loser.
Hansel has no money and trying to raise £25k from a portfolio where the properties are worth £100k and there is a £70k mortgage is going to be very expensive and once refinance costs are taken into account, there isn’t much left of the £5k equity.
Gretel on the other hand only needs to refinance one property buck up to 75% and she is able to pull out £50k. She has the deposit for both houses and inches ahead of Hansel 12-10.
Tom & Jerry are identical twins and as fate would have it, are very similar to Hansel & Gretel in that they have 10 properties each. Jerry has his on capital and interest repayment while Tom is on interest only. Where they differ to Hansel and Gretel a bit is that they have a different lender or mortgage product on each of the properties – basically they went whole of market and looked for the best repayment or interest only deal at the time.
Jerry is repaying each loan every month. He is chipping away at each one and he feels like a rock star. Of his 10 loans, some will have cracking rates of interest and some will have adverse rates of interest yet all are being treated equally.
Tom looks through his list and picks the mortgage with the worst rate. The other 9 he discriminates against and cold heartedly ignore them giving all his attention to the worst one.
By always focussing on the highest rate mortgage Tom will pay off his debts faster. If he ever comes across a cracking deal, he can do what Gretel did if need be.
Mortgage products charge a higher rate for the higher the LTV. The converse is, the lower the LTV the cheaper the rate. The mortgage market changes all the time but in broad principles the rates get a whole lot nicer at 60% LTV or less.
Tom has 2 refinements to his approach:
A – He could focus all his efforts on the highest rate mortgage loan until the debt was paid off. It works but there is a real opportunity costs to doing this.
B – He could focus all his efforts on the highest rate mortgage loan until the LTV was at 60%. He could then product swap or move to a new lender and benefit from the lower rate. He would then sit down and pick the next worst mortgage product and focus on getting this one down to 60% LTV before another product swap/refinance and move onto the next loan.
Jerry would eventually get to the same position but by treating a 2.75% loan the same as 6.4% loan it would be a slower process.
I buy houses that generate around £5k a year in gross income and generally have 25 year terms (although 35 years seems to be the trend with company mortgages which I like a lot!)
I always try investigate the properties history – when it last sold and what they last paid for it. I also look for surrounding properties to get an idea. Land Registry records as available on Right Move now go back further than they used to a while ago which makes this investigation easier.
When I go back 25 years to see what they paid for it – out of interest – the range all seems to be at around the £10k – £12k level. This got me thinking….
Assuming they were purchased 25 years ago with 100% LTV interest only mortgages, one could use the income in one of the manners described above for years 1 through to 23. Then, year 24 & year 25 apply all the rent to paying off the mortgage.
And maybe I have miscalculated so maybe income from year 23 would also be needed to crash the mortgage. But even so, if you have had the benefit of 20+years income, losing a few years at the end is not going to be too hard to deal with I’d imagine.
Unless you married into money, inherited some or a city banker you will likely start your property journey with more dreams and ambitions than anything that looks or smells like money. As a result, credit cards, overdrafts and angel finance all become essential tools early on for acquiring property.
The successful then start to silently incorporate savings into the business model and plough these back into growing the portfolio. Compounding – the 8th wonder of the world according to Einstein.
As you progress, getting rid of the short term debt (angel, cards, overdraft) should become the goal. The portfolio should become self-sustaining and self-sufficient. Further down the line you want security and to protect what you have – this means reducing your LTV.
Romeo and Juliet each have the magic 52 properties in their portfolio and are now looking to stabilise and secure the portfolio for them and future generations. This is the conservative and sensible thing to do.
They both adopted the one core strategy of buy, fix, refinance once and once only. Over time the property value should increase which will bring the LTV down overall. However, there are two key options to bring your LTV actively.
Romeo adopts the same philosophy of Tom in paying off the debt. By picking the worst rates and getting to 60% LTV he eventually gets all properties to this magic level. He then starts again and pays off the worst 60% rate mortgage.
Juliet takes a more aggressive approach to being conservative. Instead of doing what Romeo does, he instead buy property 53 for cash. In fact, all subsequent purchases are cash purchases. His debt level – in absolute terms – does not decrease. It remains the same. However, relative to his asset base, the LTV is decreasing with each new purchase.
The total level of income is also increasing compared to Romeo as more properties are being added.
The overall asset base is also increasing compared to Romeo which over time, should increase the equity and net worth of Juliet considerably over Romeo.
BB looked at his worst mortgage rate, say 6%, and looked at the net cash yield or ROI from a new cash purchase, say 9%, and thought his money would work harder acquiring assets for cash and not paying reducing debt.
In broad terms, we are in the lowest period of the 300-off year history of Bank of England base rates so for a while this should be an easy calculation to do. When rates go to 10% plus then the case for reducing debt would be far stronger.
Finally – there is also a mixed strategy that combines the best of Romeo and Juliet in paying off some horrible debt, getting some mortgages paid down to the 60% level where they are already not far off that level anyway as well as acquiring new assets.
There is more I could say but the above are some of the key thoughts I have on mortgages and the debate on interest only vs interest and capital repayment. Hopefully you have learnt something or at least considered your options available?
There are various keys to success, or things that tilt the odds in your favour. Finding a strategy that sits with your personality is one of the keys as well as one that is aligned with your network, capital, skills, time, etc. Your attitude to risk is also crucial as well as having a sustainable long term vision for the business.
However, debt – even good debt – comes with a risk and being able to manage that risk is absolutely crucial. What we haven’t explicitly mentioned or touched on in any depth really is personal financial money management. If you are crap at this I would say just one thing: Learn to manage your money better! This is a key skill not generally mentioned but is fundamental to your long term financial success.
And if you know yourself, and haven’t worked on these personal financial skills, then paying off mortgages (even in the inefficient manner of paying them off equally), will over time prove far better than using the surplus funds to fund a lavish lifestyle.
My final comment on the debate of interest vs capital repayment, as quoted by one of my mentors, is “there is no debate!!!”