Which is better Capital Repayment or Interest-Only


First of all, what are we talking about when someone says capital repayment or interest only. Mortgages. The mortgages you can get from the bank are normally either Capital repayment or Interest only with Buy-to-lets, normally with residential mortgages they are only capital repayment, but I’ve heard of exceptions to this especially prior to the sub-prime mortgage crash around 2008.


With a mortgage, you receive a loan from the bank whereby you agree some form of payment for them lending you the money at a particular interest rate, for example you require £100,000 in order to purchase your new house or buy-to-let property and they say, yep that’s fine as long you agree to pay us a rate of 3% per annum (per year) on the outstanding mortgage. So at the start of you owning this liability (something that regularly takes money out of your account) of £100,000 you would pay £3,000 per year, or £250 per month.

(Calcs: £100,000 * 0.03 = £3,000, £3,000/12 = £250).


Breakdown


Now an interest only mortgage is one where this £250 interest payment is all you pay each month for having this loan, and the interest payments will always be £250 as the outstanding mortgage figure won’t change.


A capital repayment mortgage on the other hand, you pay this £250 every month and you also pay an additional amount to chip away at the outstanding mortgage. For instance, you may pay a total of £350 on a capital repayment mortgage, £250 going towards the interest and £100 going towards the outstanding mortgage. In this scenario, at the end of the 12 months you have paid £1,200 towards reducing your liability and that would now be £98,800. What this also means is that your interest payments will be reduced overtime due to the interest rate being based on the outstanding mortgage, in this example the interest payment will have been reduced to £247 per month.


(Calcs: Total payments in the year £100 *12 = £1,200.

Remaining mortgage after 12 months £100,000 - £1,200 = £98,800.

New interest payments after 12 months (£98,800 * 0.03)/12 = £247)


Now we have a good understanding of what these two options are, we can break down the advantages and disadvantages to both.


First, Capital Repayment…

The biggest advantage to this is that you are paying off your mortgage, you are reducing that debt figure and will eventually have that moment where you own that property debt-free if you so choose.


The other benefit is that with the outstanding mortgage being paid off the interest payments will reduce over time, and although the Interest-only may start out cheaper per month than a Capital repayment mortgage, eventually this will flip with the Capital repayment being cheaper per month when the outstanding mortgage has been reduced and the interest payments falling.


Second, Interest Only…

The first advantage to be seen is that the monthly payments will be lower, at the start at least, and so you will have a higher cashflow each month coming to you to spend on other items or potentially to put away to build a deposit for a new investment.


Another advantage although does link with the first, with the fact of being on lower monthly payments, you are able to build a deposit much quicker than you would do on a capital repayment mortgage. Through the savings on several properties on Interest-only rather than Capital repayment, you will be able to accumulate more property in a shorter space of time, normally.


Now which is better, I personally think that both have there benefits to particular situations, for example I would say someone thinking more into settling into one area they may prefer to have a capital repayment in order to slowly reduce their monthly expenses especially if approaching retirement, and there are situations where someone can only buy through a capital repayment which is also good, because it still gives them the opportunity to get on the ladder.


My personal opinion


In regard to building a buy-to-let portfolio I would have to say I am personally in favour of the interest-only mortgage.


The reason being that…

1. Through the reduced monthly payments, I can save for the next property in a shorter period of time, which since I am thinking long-term in building a large portfolio this would help speed up that goal.

2. Although the mortgage is not being reduced, the value of the debt is being depreciated. What I mean by this is that due to inflation each year, the value of money is being reduced, for example £1 may buy you a 4 pint of milk now, but in 1 year it may now cost £1.09. The value of that £1 has been reduced although it is still the same £1.

To put it in property terms, £100,000 20 years ago may have bought 10 houses but now that may only be able to buy 4 at most.

Why is this an advantage, in 20-40 years, depending on the mortgage length, what is that outstanding mortgage going to be worth most probably a lot less, and with the value of property’s doubling on average 9-10 years, the value of that mortgage is going to be a lot less at that time.


Another point to note is that with Section 24 coming in over the next couple of years, mortgage interest payments will soon no longer be able to be deducted from rental income in Buy-to-lets through sole names, and so the cashflow is going to be reduced even further if you have a capital repayment mortgage also.

*If you are unsure what Section 24 is, I am intending to write a blog about it, but please ensure that you either fully read and understand the changes or speak to an accountant in regard to this if you own properties through your sole name*


In summary, I find the interest-only mortgage much better in terms of my goals, but there are scenarios and circumstances where both can be applicable to any person and so it is best to examine your own circumstances to decide what works best for you.


Thank you for reading.


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