MORTGAGES – Interest only or return of capital?


My personal view is that an interest only mortgage is much better than a principal repayment mortgage, here’s why…

In 1971 my parents borrowed three times their joint income to buy a house which cost them £3,000. Yes, you read that right, THREE THOUSAND POUNDS, and that bought them a three-bed house in South Staffordshire.

They put down a 10% deposit and took out a mortgage for the balance of £2,700. It was a real blow to them because mortgage interest rates were five times higher than they are now.

Their bank manager persuaded them with financial logic that they’d be much better off having a 15-year payback mortgage, so they did, despite their household’s cash flow crippled. It was a bank manager’s financial logic, NOT an entrepreneur’s financial logic.

Now moving on to 2022, the house is now worth £300,000. If they had taken out a single interest mortgage of £2,700, their monthly repayments today, assuming, say, an interest rate of 2%, would be just £4.50 a month.

Was it really worth crippling their cash flow all those years ago, giving up vacations and “living with it”?

What if they had only taken mortgage interest and re-mortgaged their property, say every 10 years, and used the funds as deposits to purchase more rental properties? Would they already be multi-millionaires? I think they could have been,

However, life never turns out exactly the way you planned, does it? In fact, after 10 years, my parents took out a second mortgage to pay for the double glazing, a new front door and to build a garage. A few years later they sold their property and bought a much bigger and more expensive one, again with a much larger mortgage. They were always on the verge of going broke as a result of advice given to them by their bank manager.

On the other hand, my brother and I did things very differently. We have always only taken interest in mortgages and refinanced as much equity as possible on the properties, to serve as deposits to buy more properties. However, we didn’t take big risks (in our opinion) because we also hoarded the money we would have paid if we had taken out 15-year repayment mortgages. Our thought process was very simple; if we needed cash that we had paid off on our mortgages, we would be at the mercy of the banks to lend it to us. However, if we had the money, we were masters of our own destiny.

This strategy has worked well for both of us, as life always throws a “curve ball” at you from time to time. At times, interest rates rose, tenants stopped paying rent, properties were vacant and didn’t produce any rent, unexpected maintenance issues occurred, and a few properties were ransacked. It didn’t hurt too much because we had money in the bank to deal with those scenarios.

Also consider that as property values ​​drop, it becomes more difficult to borrow. When you face a crisis situation, such as a desperate need for cash or unaffordable mortgage payments, would you rather have a slightly smaller mortgage or extra cash in the bank?

Why pay off low-interest debt and then borrow again with higher margins when you need cash? Real estate investing involves positive cash flow and cash management. In my opinion, there is no reasonable argument for making principal payments on the mortgage, especially if you are still growing your portfolio or need to access financing for other purposes.

My real estate investment strategy

My early career was in financial rescue and risk underwriting. It was the late 1980s, property values ​​had plummeted and interest rates had risen to 15%.

The real estate investors facing financial ruin during this era all had one thing in common, and it wasn’t what you might think. It wasn’t a high gear, despite collapsing real estate values, it was a cash crunch. Investors with high leverage and high liquidity (cash at bank) performed well. It taught me that “cash is king” and that any remaining equity in the property is at high risk.

Why I Believe Real Estate Investing Makes So Much Sense

A large number of people choose not to own their own home for various reasons and prefer to pay rent for the privilege of occupying a property. In fact, in the early 1900s, over 90% of people in the UK lived in rented accommodation. This figure fell to a low point in 1973 at just 7% of the population.

The basics

I use rental income to pay mortgages and management, maintenance and insurance expenses associated with the property. Over time, inflation and other factors increase the value of my properties and the rent. However, my mortgage balances remain constant, assuming of course only interest is paid. As a result, over the years, the gap widens between rents collected and total expenses, creating an improved cash position. Rising property values ​​also increase my net worth. A strategy of borrowing “cheap money” to buy property is therefore an effective method of accelerating my wealth by using other people’s money.

Why I freed up capital whenever a realistic opportunity to do so presented itself, especially during my first two decades in this business

It is a matter of risk transfer. If the equity is left in the property and the property loses value, the equity may no longer be accessible and I take all the risk. However, once the property is refinanced, I control the liquidity and the risk is transferred to my lenders for which they earn higher interest returns.

The following simple example might explain this better.

Suppose I own an investment property worth £100,000 without a mortgage.

One morning I wake up, turn on the TV and watch the news that property values ​​have dropped by 50%.

My property is now worth £50,000.

Before that I could have taken out a £75,000 mortgage and kept the money in the bank. I would then have a property worth £50,000 and a mortgage of £75,000. Therefore, I would have £25,000 of negative equity!

Would I be in danger? Don’t forget that I would still have £75,000 in the bank.

So what are my choices?

I could pity the bank. After all, the bank now bears the risk. If so, I could pay off the mortgage, or,

I could just keep the money in the bank, or

I could use some of the money to buy cheaper properties and save some for rainy days.

If I hadn’t refinanced, I might find it difficult to raise funds because the banks would be nervous about lending at this stage. If I then decided to get funding, I would probably pay more for it. Also, if I could then borrow 75% of the value of my property, I would only be able to raise £37,500.

If the market goes the other way and property values ​​rise, another window of opportunity could well open up to free up even more equity.

What are your thoughts?


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