I’m pretty confident that most of us know the basic principles of mortgages. You can take an interest only product that gives you higher cashflow every month but you never repay the capital. Or you can go for a repayment mortgage where your monthly payments are higher but at the end of the mortgage term you’ve also paid off the loan amount, meaning you then own that property outright.
Both have their place, and in the property investment world an interest only mortgage can really help you maximise your cash flow to replace an income quicker or to allow you to reinvest.
But how much does that extra cash flow actually cost you? And what would happen if you went against the common ‘wisdom’ and not only paid back the capital but also made overpayments?
We explored the impact this would have over the life of a mortgage in this video:
As with most investment options, there is no single right answer. Many of us rely on the income from our portfolio to live, so making capital repayments (never mind overpayments) would be a struggle.
Why not invest the money elsewhere?
Also, from a pure mathematical ROI point of view, with interest rates so low, the money you use for repayments/overpayments could be invested elsewhere for a higher return than the savings on your mortgage would generate.
For example a lot of people suggest that instead of making overpayments on a mortgage you should take that £200 a month and invest it into your next property instead. Your mortgage would cost you 3% or 4% per year so if you can buy an HMO that makes you 15% or 20%, you’re better off doing that.
I don’t entirely go along with this argument though as most of the investors I speak to have small portfolios so using the retained cash from interest only mortgages to buy another property would take many years to accumulate enough for a deposit.
“Saving £200 per month instead of making a £200 overpayment would take 8 years and 4 months before you have saved a £20,000 deposit for your next deal.”
Equally whilst an academic exercise suggests higher returns can be achieved, I doubt many of us are diligent enough to filter off that money every month and actually reinvest it. If you are then fantastic. Mortgage overpayments probably aren’t the answer for you, but for the rest of us financial mortals it’s a great starting point.
Just tell me the numbers
If you can’t bring yourself to watch me try and understand mortgage payments in the video, then I’ve summarised the numbers in a simple example below:
It’s clear to see the pros and cons of each option. Interest only obviously gives the greatest monthly cash flow, allowing you to live off more of the income from your investments and/or reinvest the difference for higher returns.
Repayments result in a significant reduction in the total interest paid but the small extra expense also results in an unencumbered property at the end of the term – something a lot of us aspire to!
Finally with overpayments, even a small additional contribution every month (£200 in this case) does eat into your immediate cash flow but reduces the interest over the term of the loan by a further £40,000 AND means your mortgage is paid off over 6 years early!
My advice at the moment is to keep strong cash flow as you grow your portfolio with interest only mortgages, but once you hit your target income, everything else should go towards paying down your mortgages as soon as possible.
With changes like clause 24 and possible interest rate rises on the horizon, lowering your loan to value ratio will have real positive benefits long into the future.
Feel free to share the image above. I’d love to hear other opinions on this divisive subject!