Key Post Interest only mortgages for investment property

Brendan Burgess

Founder
Messages
37,694
From Irish Independent 7 October 2004

Founder of website askaboutmoney.com BRENDAN BURGESS outlines the arguments for using an interest-only mortgage when buying investment properties

IF YOU are investing in property, you should take out an interest-only mortgage, unless you are not on the top tax rate. In particular, you should always pay off your home mortgage before making any capital repayments against your investment property.

You should borrow the maximum amount possible, bearing in mind the usual warnings about borrowing to invest.

Why?

You can write off the interest against the rental income in calculating your tax. So the real cost of interest is reduced by 47pc. So if you are paying 3.5pc interest, the net cost is only 1.9pc after tax.

Consider the following:

You have a €100k interest-only mortgage and you have a lump-sum of €10,000. Do you pay the €10,000 off the mortgage or do you invest it somewhere else, e.g. an equity fund?

By paying it off the mortgage, you will save only 1.9pc a year. Over the long term, you can expect to get a return well in excess of 1.9pc a year in an equity fund. So you should invest this money rather than pay it off your mortgage.

So you should never pay any capital off a commercial mortgage. If you have a repayment mortgage, you should switch it to an interest-only mortgage.

An interest-only mortgage is even more advantageous if you have scope for contributing to a pension fund. You will get full tax relief on the payment into the pension fund.

The pension fund returns will not be subject to tax. You will get 25pc of the accumulated fund tax free on retirement. You will pay a maximum of 42pc income tax on the balance.

Why are you investing in property at all? The main attraction in investing in property is that you can write off the interest against the rental income. If you are investing money which is not borrowed, you should be investing in equities.

The long term return is higher, the transaction costs are a lot lower, it is easier to diversify, equities are more liquid, and it is a lot less work.

Are there any exceptions?

The main exception is if you are not paying tax at 42pc. Then the tax write-off is worth a lot less. However, if you are not paying tax at 42pc, you should probably not be borrowing to invest in property at all.

Some arguments used against repayment mortgages

The amount borrowed is very high as a proportion of the value of the property.

You should not look at any individual property or individual loan in isolation. Look at your total assets and borrowings. If you have an investment property worth €200k with a €200k mortgage and a home worth €300k, then your loan is only 40pc of your total property.

If you have a mortgage on your home, then you should be repaying the home loan first as the interest attracts little tax relief.

You will still owe the full capital amount in 20 years. With a repayment mortgage, you will owe nothing.

This is misleading. You won't be throwing away the capital repayments you would otherwise have made.

You will presumably be investing them elsewhere. If you have managed to get a return higher than 1.9pc on the money invested, your investment will exceed the value of the mortgage.

Some people with interest-only mortgages don't realise that they will still owe the full capital amount in 20 years time.

Investing in property is a risky business, and people who don't understand the full implications of what they are doing should reconsider whether such investment is appropriate for them.

However, the fact that some people don't full understand a financial product does not mean that it is a bad product.

Interest rates may rise.

Interest rates will rise and fall over the next 20 years. Over the long term, you can expect the return on your investments to exceed the after-tax cost of borrowing.

If there is some long-term change to the investment environment, where you can no longer expect returns to exceed the after -tax cost of borrowing, then you should pay off your loans.

Over the long term, you will pay a lot more interest.
Correct, but you will receive a lot more interest or income on the repayments invested. Repaying a mortgage is a good discipline.

You might squander the capital repayments instead of investing them.
This is not a valid argument against interest-only mortgages. This is an argument against squandering money.

You might invest the capital repayments badly

OK, so a bank might encourage you to take out an interest-only mortgage and to invest the proceeds in a badly-performing tracker bond or endowment policy. This is not really an argument against interest-only mortgages.

It is an argument about investing wisely. It is of course better to pay off your mortgage than to throw the repayments away.

If someone is buying one property hoping it will provide an income when retirement comes around, they best take a repayment mortgage.

Not correct. They will be better off with an interest-only loan if they invest the capital repayments they saved in another investment. Of course, they will be better off if they repay their mortgage instead of squandering the repayments.

Interest-only mortgages are just another form of endowment mortgages

Endowment mortgages were over-sold to people for buying their own homes. They got no tax relief on the interest paid, and the capital which should have been paid off their mortgage was invested in a poor investment.

You are of course better off paying down your interest-only mortgage than squandering your money or investing it badly.
 
N

ninsaga

Guest
Brendan,
Can you please clarify a point...

If someone is buying one property hoping it will provide an income when retirement comes around, they best take a repayment mortgage.

Not correct. They will be better off with an interest-only loan if they invest the capital repayments they saved in another investment. Of course, they will be better off if they repay their mortgage instead of squandering the repayments.
...does this mean that one should be setting aside & investing the extra money that would otherwise be used to pay off the loan if it were a repayment mortgage? If it does then it would assum that the investor has the extra money at their disposal - which is not always the case ...then again maybe I'm not picking up on the point clearly.

Secondly, shouldt the term for Interest only should be extended to the maximum allowable from the lender? ie if 10yr is the term for interest only then take it.
 

Brendan Burgess

Founder
Messages
37,694
Hi ninsanga

It is suggested that people are better off with a repayment mortgage if they are relying on the investment property for retirement. This is because when they retire, they don't want to have a big mortgage.

You are saying that they might not have the money at their disposal? If they don't have the money at their disposal to invest so as to build a lump sum which might be used to pay off the capital, then they won't have the money available to make the extra repayments which an annuity mortgage demands.

I am not sure where you are getting the 10 years from. If you have an investment property, you should have an indefinite interest only loan. In other words, you should never pay it off while you still own the property.

Brendan
 
N

ninsaga

Guest
OK - I took it that some lenders had a maximum term for interest only ie 10yrs.

cheers
ninsaga
 
O

oilean

Guest
A lot of lenders do have a fixed term and some not for a 20 year period

So if you go 10 or 20 years you can just remortgage at that time

If you are borrowing in the region of €200,000 the associated legal costs will usually be paid for out of the interest rate reduction in the first year of the new mortgage

Stu
 
F

frescoflyer

Guest
Hi there,

Having read your article, below

www.unison.ie/irish_indep...si=1263638

.. I still believe these points still need to be factored in:-

1) Property prices drop below purchase price.

Never say never. Look at the equity markets during the boom. People were wishing and convinced it would last forever. Alot of money was lost during the collapse, both in pension funds and personal investment.

Who knows how the markets (equity, property..whatever) are going to behave over the next, say, 20 years.

It is something worth keeping in mind.

2) Interest relief reduced or stopped.

Could this happen in the future. This would have a huge impact on money pocketed as a result of increased income tax payments.

3) Interest rates increase.

When (and if!!) interest rates increase in the future, will there be an interest relief increase in direct proportion to this interest rate increase? If so, there there is little impact, as the relief will absorb the rate increase. Otherwise..more exposure.

I am a property investor of two properties (one local, one foreign). I am still committed to property investment but I believe one need to have a rational chat with oneself and factor these risks in.

It is similar to a jewel of advice when investing in shares; "Can I afford to lose / repay the money invested if it all goes pear shaped".

Cheers.

Fresco.
 
F

frescoflyer

Guest
Hi,

Another point I forgot to mention was the following:-

If interest only is selected, could this be a black mark permanently on one "Credit Worthy" history?

If one chooses to take a loan out in the future - 10, 20 years on even; if the lending institution you want the loan from checks your credit history, the capital sum outstanding will jump out at them.

Depending on the estimated value of the property at that point in time, it could prevent subsequent loans.

What do you think?

Cheers,

fresco
 

Brendan Burgess

Founder
Messages
37,694
1) Property prices drop below purchase price.

This makes no difference to whether you have a repayment mortgage or an interest only mortgage. You will have saved the capital element of your repayments in another investment medium, so you can pay this off your mortgage if it makes you feel better not having negative equity.



2) Interest relief reduced or stopped.

Absolutely. If the interest relief is scrapped, then the mortgage should probably be paid off.

3) Interest rates increase.

If the interest rates rise to such an extent that you no longer expect to get a net return on your investment in excess of your net cost of interest, then you should repay some of the capital.

4) Credit history

This is an interesting issue. If you have an interest only mortgage and you have been investing the capital repayments wisely, you will have a lump of money so you won't need to borrow as much.

Brendan
 
K

KBR909

Guest
Brendan & Others,

Could you comment on the rates you get on interest-only mortgages? I haven't looked into it fully, but I know that EBS loads an investor with an extra 0.5% over the standard variable rate for residential owners.

Is this common among lenders in your experience, & are Interest Only mortgages similarly loaded?
 
N

novice2004

Guest
Interest only

Brendan,

Would a good strategy be to use the rental income profit to increase the repayments on your mortgage for your PPR? This would simplify the choice of investment for me.

I'm considering taking out an interest only mortgage for investment, I presently have 200k left on my home mortages (equity of 300k approx).

Regards,

RK.
 

Brendan Burgess

Founder
Messages
37,694
Re: Interest only

Hi novice

That is exactly the correct strategy. Always pay off the mortgage on your home before paying off the mortgage on your investment property.

Brendan
 

s2000

Registered User
Messages
44
Re: >>Interest only mortgages for investment property

Is it not fair to say though that interest only mortgages are a good idea for a long term property investment. Example.

Buy a property for 200k on an interest only mortgage. Say you pay only the interestfor 15 years (if allowed). In 15 years you owe 200k on the property. BUT, in 15 years time 200k will not be what it is now and the house will be worth more then 200k, well more.... money devalues, property values (even is just with inflation).
 

ClubMan

Frequent Poster
Messages
43,858
Re: >>Interest only mortgages for investment property

s2000 said:
Is it not fair to say though that interest only mortgages are a good idea for a long term property investment.
Yes - isn't that one of the main points made in the original post that started this thread?
 
M

mercW123

Guest
Re: Key Post: Interest only mortgages for investment property

Brendan,
I just joined recently and am reading htis thread for the first time.
Would you still be an advocate of the interest only mortgage for investing in a second property ?
 

lazing

Frequent Poster
Messages
63
Re: Key Post: Interest only mortgages for investment property

Brendan,

I note the lack of reply to mercW123.

I'm reading Nassim Nicholas Taleb's "Black Swan" - basic idea is to always factor in extremes - and I guess changes in government policy / investment conditions.
 

Brendan Burgess

Founder
Messages
37,694
Hi Lazing

The post set out the principle. I said the following about risk. Bear in mind that this post was written back in October 2004

If you are investing in property

...

You should borrow the maximum amount possible, bearing in mind the usual warnings about borrowing to invest.
...



Investing in property is a risky business, and people who don't understand the full implications of what they are doing should reconsider whether such investment is appropriate for them.
In retrospect, I would probably have spelled this out a bit more.

This is what I said in April 2002 in the Property Investment FAQ.

Investment property is not risk free. House prices are not guaranteed to continue rising forever. If you borrow to invest in property, make sure you can handle a serious downturn in prices.
This was not a prediction about house prices. As I have said consistently, and said in January 2002, I don't claim any ability to predict house prices. What I have been clear about is that if you are borrowing to invest in anything, you must be able to handle the downside.



The following piece could be queried in retrospect



Over the long term, you can expect to get a return well in excess of 1.9pc a year in an equity fund. So you should invest this money rather than pay it off your mortgage.
Over the period of 5 years since this was written, there has not been a return of 1.9% a year. With the benefit of hindsight, it would have been better not to invest in the stockmarket. But investing in property is a 20 year commitment, so I would expect that someone investing for 20 years will probably be better off on an interest-only mortgage.

Of course, in retrospect, the best strategy of all would have been not to have invested in property.

I have consistently said, in this post, and in others, that borrowing is risky and should only be undertaken, if you can handle the risk.



So would I change the overall advice in the post now? The principle remains the same. But the tax treatment has changed and the interest rates are relatively higher. Again, I anticipated that. So people with interest only mortgages, need to do the sums again now as in this recent post.



If there is some long-term change to the investment environment, where you can no longer expect returns to exceed the after -tax cost of borrowing, then you should pay off your loans.
 

Brendan Burgess

Founder
Messages
37,694
One very important point to stress is that I have never recommended investing in property. I have always stressed that the expected long-term return from shares is much higher than that from property.

The first word in the article is "If". In other words, if you have made the decision to invest in property, then you should borrow on an interest only basis.

In this article I stress that if you are not borrowing to invest, you should not be investing in property:

If you are investing money which is not borrowed, you should be investing in equities.
 

lazing

Frequent Poster
Messages
63
Brendan,

I very much appreciate your response.

I wouldn't be as definitive as the closing statement - "If you are investing money which is not borrowed, you should be investing in equities."

There are many other types of investment that may be more suitable, dependant on the individual: gold / commodities, interest rates / fx, and so on.

Also each investment needs to be judged on its own merits. In some circumstances property can be a better investment - particularly if someone can enhance it using their skills (design / architecture / etc).

I believe there is no single right way for everyone. It depends on individual circumstances, desires, risk profile and ultimate goals.
 

Bronte

Frequent Poster
Messages
13,305
Of course, in retrospect, the best strategy of all would have been not to have invested in property.
I don't get this? Many people have invested in property and have gained?

Also your final point about interest rates. They are at a historical low?

You are correct about the tax treatment changing. If one is investing in property one needs to look at everything but
'does the return justify the investment being the most important'.
 
Top