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

Landlords have several difficult choices to make - where to invest, what type of property to buy and which target market to cater to.

Another important decision is the mortgage you choose to finance a buy-to-let investment.

Picking the right mortgage could knock thousands off how much you repay in total, so it's vital to compare and get the best deal.

But you’ll also need to decide whether to use an interest-only or repayment mortgage.

The difference between interest-only and repayment mortgages

One of the main costs you need to consider when you’re taking out a mortgage for a buy-to-let property is the interest rate you’ll be charged and how much you could end up repaying overall as a result.

There are two ways interest can be charged on a mortgage and it’s important to understand the differences between them to help you make the right choice.

With an interest-only mortgage, you only pay the interest on your mortgage each month - you don’t need to pay off the original loan amount (the capital) until the end of the mortgage term.

Most landlords, especially those with more than one property in their portfolio, use interest-only mortgages to finance their investments.

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

Some landlords use rising house prices to release equity from their properties by remortgaging, then they invest this money in new properties, this process is 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 (LTV) criteria.

Advantages of interest-only mortgages for landlords

You’ll want to consider that:

• The monthly repayments can be hundreds of pounds less than with a repayment mortgage
• It can help you to keep your overheads lower and finance other properties
• Having less to pay each month can provide a safety net for times when there's no rent coming in
• You might make a profit when you sell the property as well as covering the loan amount
• Interest-only mortgages can be tax-efficient depending on your situation

Disadvantages of interest-only mortgages for landlords

Don’t forget that:

• You won’t own your property at the end of the mortgage term because you haven’t been paying off any capital
• You may have to provide a larger deposit as they’re considered more of a risk by lenders
• Some lenders will want proof of a repayment plan - for example, using ISAs, pensions, or equity
• You’ll pay more interest because you haven’t been paying off any of the mortgage balance
• You could end up out of pocket if house prices fall and your repayment plan underperforms
• Being unable to repay your lender in full at the end of the term will affect your credit rating

What’s a repayment mortgage?

An alternative option if you want to buy a rental property is to take out a repayment mortgage.

Your monthly repayment will be made up of two parts - the capital and the interest.

In the early part of the mortgage, the bulk of what you pay will go towards the interest. But the amount you owe will decrease in line with the size of the loan.

Once you make the final payment at the end of the mortgage term your balance will be paid in full and you’ll own your property outright

• The amount of interest you pay decreases over time
• You’ll typically pay less interest compared to an interest-only mortgage
• You won’t need a repayment plan or exit strategy at the end of the mortgage term
• You’ll own your property in full by the end of the term
• You can often reduce the cost by switching to a deal with a lower fixed or variable interest rate At the end of the term, you can continue to rent the property out and keep all the income Buying a rental property this way can be a way of boosting your income in retirement

Disadvantages of repayment mortgages for landlords

Watch out for:

• The monthly repayments usually cost a lot more than an interest-only mortgage
• There are fewer lenders that offer buy-to-let repayment mortgages
• You may need to use a specialist mortgage lender
• Because the monthly payments are higher, some lenders offer lower maximum loan amounts
• There’ll be a higher monthly amount to cover during times when you don’t have rental income

Can you have a combined interest and repayment mortgage?

Think about:

• The amount of interest you pay decreases over time
• You’ll typically pay less interest compared to an interest-only mortgage
• You won’t need a repayment plan or exit strategy at the end of the mortgage term
• You’ll own your property in full by the end of the term
• You can often reduce the cost by switching to a deal with a lower fixed or variable interest rate
• At the end of the term, you can continue to rent the property out and keep all the income
• Buying a rental property this way can be a way of boosting your income in retirement

Disadvantages of repayment mortgages for landlords

Watch out for:

• The monthly repayments usually cost a lot more than an interest-only mortgage
• There are fewer lenders that offer buy-to-let repayment mortgages
• You may need to use a specialist mortgage lender
• Because the monthly payments are higher, some lenders offer lower maximum loan amounts
• There’ll be a higher monthly amount to cover during times when you don’t have rental income

Can you have a combined interest and repayment mortgage?

Yes, it’s possible to have a kind of hybrid mortgage solution, often known as a ‘part and part’ mortgage.

So, instead of paying back the full loan plus interest like you would with a repayment mortgage, you only pay back an agreed percentage of the loan and the interest each month.

This means when the term ends, there’ll still be some remaining capital that you’ll need to repay.

Changes to the tax advantages of buy-to-let mortgages

Up until 2016, mortgage interest payments could be fully offset against rental income, which could make rental properties tax efficient.

However, since April 2020, changes have been introduced by the government to phase out tax relief on rental income.

These changes mean you’re no longer allowed to deduct your mortgage expenses from your rental income to reduce how much tax you need to pay.

Instead, there’s now a flat-rate tax relief of 20% on rental turnover, rather than profit.

Landlords who pay a basic tax rate shouldn’t see any change and can still take advantage of some tax benefit. But those who are higher rate taxpayers will now lose a lot more of their income to tax, potentially making rental properties much less profitable.

The new rules also mean some landlords might be pushed into a higher tax bracket because they now need to declare the income they’d previously used to pay the mortgage.

Is a buy-to-let a good investment?

This depends on a number of factors. To start with you should consider your investment objectives and do your research on the type of property and area you intend to buy in.

As well as providing rental income, if chosen well, a property investment can mean you achieve capital growth too. You will need to keep in mind Capital Gains Tax rates in the UK. You will also pay a different rate of tax on gains from residential property than you do on other assets. You can read more here. 

However, a buy-to-let is typically more of a long-term investment and while it can deliver some good returns, this won’t usually happen quickly.

You should also bear in mind there’s a risk you’ll be left out of pocket if the property drops in value.

Plus, any investments you’ve made as part of a repayment plan to clear your mortgage might do poorly and leave you without the cash you need at the end of the term.

Nevertheless, most landlords expect to ride the ups and downs of the property market and are prepared to invest in the longer-term potential.

Can you switch from interest-only to a repayment mortgage?

Yes, it’s possible to switch during the term of your mortgage, but this will depend on how much your loan is and whether your lender will allow it.

If your lender won’t let you switch, you may be able to remortgage when your current deal finishes and get a repayment mortgage with a different provider.

Because the monthly payments for a repayment mortgage are typically higher than an interest-only mortgage, it’s likely you’ll need to prove to the lender that you can afford them.

How to apply for a buy-to-let mortgage

There are certain criteria you’ll need to meet to be eligible for a buy-to-let mortgage which usually include:

• Owning your own home outright or with an existing mortgage
• Having a good credit rating
• Earning an annual salary of more than £25,000
• Being under 70 or 75 years old when the mortgage term ends

Compare a range of mortgages to see which one will best suit your needs and get advice from an independent financial adviser or specialist broker if you need help.