Is interest-only or repayment best for buy-to-let?

Key points

  • Landlords frequently choose interest-only mortgages as they can boost their investment's potential
  • Interest-only mortgages can offer flexibility and tax benefits, but this will change in 2017-18
  • If house prices fall you'll have to make up the difference when you come to repay the debt

Landlords have a lot of difficult choices to make; where to invest, what kind of property and what kind of target market.

But an essential choice is what kind of mortgage to go for to finance a buy-to-let investment.

The difference between the mortgage rates available can add up to a difference of thousands of pounds over the lifetime of the deal, so it's vital to compare the market and get the right support.

But another key question is whether to use an interest-only or repayment mortgage for the investment.

The difference between interest-only and repayment

For rent signMost landlords, especially those, with a portfolio of more than one property, use interest-only mortgages to finance their investments.

For many new or aspiring landlords that can seem odd. After all, with a repayment mortgage you pay down debt every month until the end of the mortgage when it's paid off.

Repayment mortgages costs more month to month and in the early days the bulk of the payment is interest, but by the end the property belongs in full to the landlord.

With an interest-only mortgage, the monthly payments are lower but you don't pay off any of the capital - it must all be paid back at the end of the mortgage term.

To anyone new to the buy-to-let market, interest-only mortgages can seem worrying. After all, they're considered pretty risky for residential mortgages.

But buy-to-let is a very different kettle of fish and the financing considerations are also very different.

Advantages of interest-only mortgages for landlords

The National Landlords Association reports that most landlords choose an interest-only mortgage but, unlike residential buyers, do not plan a separate repayment vehicle.

That's because the rental income covers the monthly interest and the majority of landlords see buy-to-lets as a long-term investment.

They plan to sell the property in the future and make a profit from any house price inflation, as well as repaying the capital owed.

The key benefits to interest-only mortgages for landlords are flexibility and tax efficiency, although the amount of tax you can save is changing.

In terms of flexibility, interest-only mortgage payments are simply lower than if you're also making repayments.

That means you have lower overheads, which can be a big plus if you're trying to expand your portfolio and finance other properties.

Some landlords use rising property values to release equity from their properties by remortgaging, then investing it in new properties, sometimes referred to as 'leveraging'.

Done carefully, landlords can still remortgage to a new interest-only buy-to-let product because they leave enough equity in their property to meet the minimum loan-to-value criteria.

Tax advantages of interest-only mortgages

Up until 2016, mortgage interest payments could be fully offset against rental income, which can be very beneficial for tax planning.

For example, if a property is let for £1,000 a month and the interest-only mortgage payments are £600 a month then there's only £400 to be taxed each month - and that's before other expenses are factored in.

How to be a landlordHowever, if you were on a repayment mortgage then your monthly payments would be closer to £900 but you'd still only have a tax-deductible amount of £600.

Not only that but as you clear the mortgage and the tax-deductible element of the debt goes down, the amount you owe in tax will rise.

Instead of spending it on repayments, you could choose to put that cash into a tax-free vehicle like an Isa and allow it to grow. Or you could invest it in other properties or stocks and shares.

Many landlords instead choose to take the maximum income out of their property or properties and use the money in a more profitable way - potentially generating enough to clear the mortgage in full should they ever decide to.

Government changes to landlord taxes

In measures announced in 2015, landlords will have to pay tax on their turnover rather than their profit, meaning they will not be able to deduct the cost of their mortgage interest from their rental income.

The change will be phased in from the 2017-18 tax year and fully implemented by 2020. It is likely to have a big impact on landlords' ability to make a profit.

There will be a 20% tax credit available so this won't affect smaller-scale, lower-income landlords so severely.

However, it will affect all private landlords who hold mortgages but whose rent and other income (before mortgage or other interest is deducted) exceeds the 40% Income Tax threshold.

According to the Residential Landlords Association, this could tip 60% of basic-rate taxpayer landlords into the higher rate of income tax even though their income won't actually have increased.

There are concerns that this change could leave some landlords operating at a loss.

The risks of an interest-only buy-to-let mortgage

Questions of tax aside, there are some other risks with an interest-only mortgage.

The biggest is that if house prices fall, for example as they did in the 2008 crash, you'll have to make up the difference when you come to repay the debt.

If you've been relying on selling the property in order to clear the mortgage then that can leave you out of pocket.

There's also, obviously, a risk that any other investments you've made in order to clear the mortgage (assuming you want to, perhaps as part of your retirement planning) might do poorly and leave you without the cash you need.

That is essential to bear in mind - after all, if you had to sell during a downturn then it could be an expensive attempt at investment.

However, most landlords are in for the long term and expect to ride the ups and downs of the property market.

By Felicity Hannah