Mortgages explained: buy-to-let mortgages and interest only

Posted by Chris Ledger, July 12, 2019

Mortgages explained: buy-to-let mortgages and interest only

In the world of homeowner mortgages, the idea of getting a loan and only paying off the interest would send most people running for the hills these days. When it comes to buy-to-let, however, the rules are quite different.

If you’re new to investing in bricks and mortar, the idea of borrowing a large sum of money and only paying off the interest might leave you feeling somewhat apprehensive. You also might be wondering how you’re going to pay the capital amount off at the end of the mortgage.

In this article, we’ll breakdown why people take interest only buy-to-let mortgages, as well as how they work so that you can make more informed decisions about your borrowing choices.

Difference between interest only and repayment mortgages?

Whether you’re taking out a buy-to-let or a residential mortgage, there are two main types: repayment mortgages and interest only mortgages. Repayment mortgages are the most common for home owners, while most buy-to-let mortgages are interest only.

It’s important to note that historically interest only mortgages were more commonly available for people buying their own home. Nowadays though, most home ownership is achieved via capital repayment mortgages. This is because that is considered less risky, as customers are able to cumulatively pay off both the capital and the interest over an extended period of time. As a result, they are less likely to be at the whim of the housing market, should their property go down in value.

When you first start paying off your repayment mortgage, most of it goes towards the interest. The longer you pay your mortgage off, however, the more the interest decreases and you start paying off the actual loan. Once you have finished your payments, the property is paid off entirely.

Interest only means that you only pay the interest off, with the actual amount borrowed staying the same for the duration of the mortgage. Once the mortgage term is up, you will owe the initial amount that you borrowed: eg, if you borrow £100k, at the end of the mortgage term you will still owe £100k. Borrowers need to prove that they can pay off the entirety of the mortgage once the full terms have concluded. 

Why take an interest only buy-to-let mortgage?

Borrowers who take out a residential mortgage don’t have much to gain from financing their home with interest only. While all property is an investment, the emotions involved with buying a home are likely to be more sentimental than any business transaction.

It is assumed buy-to-let investors are different, however. Making money is the primary focus of a buy-to-let investment –  in the long and short term. While an interest only mortgage might sound counter-productive, it actually makes a lot of sense.

Interest only repayments are typically much lower than home owner mortgages (around 45%). This means you should get more monthly rental income from your buy-to-let investment than if you were on a full repayment scheme. With the extra savings you could expand your portfolio or use it part of your general income. 

The dynamics of buy-to-let investing

The rules for buy-to-let interest only mortgages are different from capital repayment mortgages – deposit requirements are often higher, and the amount you can borrow is worked out using predicted rental income, as well as the loan to value (LTV) of the mortgage and something called the debt service coverage ratio – see our recent blog on stress testing to understand this.

A key consideration of choosing an interest only mortgage, is how you prove your ability to pay the capital, or amount borrowed, in full, once the term has finished. Most borrowers use the value of the property they are buying to show they can pay off the mortgage in this way.

Property capital tends to grow over time. A property purchased for £350k should increase significantly in 25 years times. While there’s no guarantee your property will increase, you only need to look at price comparisons from 25 years ago. In January 1994, the average UK property price was just shy of £55k. As of January 2019, average UK prices were £228k.

We use 25 years as a marker because that’s the average length of a mortgage. Why is this relevant, you ask? If you borrow £150k on an interest only for a property worth £250k, there is a strong chance that its value will increase five, 10, 15 years and so on.

Assuming you don’t choose to extend the mortgage further, you would sell the property, pay off the interest and be left with a profit. That being said, please do note, as with any property purchase you make, your capital is at risk if property prices go down, and you are unable to sell the property with a profit, or at all.

Navigating the world of interest only

Most landlords choose interest only mortgages because their rental income covers the monthly mortgage repayments and they’ll be able to use what’s left over how they see fit. Buy-to-lets are generally long-term investments, meaning the property should grow in value over time.

All of our buy-to-let mortgages are interest only. If you’re thinking of investing in a buy-to-let property, have a look at our product range.

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