Brendan Burgess
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From Irish Independent 7 October 2004
Founder of website askaboutmoney.com BRENDAN BURGESS outlines the arguments for using an interest-only mortgage when buying investment properties
IF YOU are investing in property, you should take out an interest-only mortgage, unless you are not on the top tax rate. In particular, you should always pay off your home mortgage before making any capital repayments against your investment property.
You should borrow the maximum amount possible, bearing in mind the usual warnings about borrowing to invest.
Why?
You can write off the interest against the rental income in calculating your tax. So the real cost of interest is reduced by 47pc. So if you are paying 3.5pc interest, the net cost is only 1.9pc after tax.
Consider the following:
You have a €100k interest-only mortgage and you have a lump-sum of €10,000. Do you pay the €10,000 off the mortgage or do you invest it somewhere else, e.g. an equity fund?
By paying it off the mortgage, you will save only 1.9pc a year. Over the long term, you can expect to get a return well in excess of 1.9pc a year in an equity fund. So you should invest this money rather than pay it off your mortgage.
So you should never pay any capital off a commercial mortgage. If you have a repayment mortgage, you should switch it to an interest-only mortgage.
An interest-only mortgage is even more advantageous if you have scope for contributing to a pension fund. You will get full tax relief on the payment into the pension fund.
The pension fund returns will not be subject to tax. You will get 25pc of the accumulated fund tax free on retirement. You will pay a maximum of 42pc income tax on the balance.
Why are you investing in property at all? The main attraction in investing in property is that you can write off the interest against the rental income. If you are investing money which is not borrowed, you should be investing in equities.
The long term return is higher, the transaction costs are a lot lower, it is easier to diversify, equities are more liquid, and it is a lot less work.
Are there any exceptions?
The main exception is if you are not paying tax at 42pc. Then the tax write-off is worth a lot less. However, if you are not paying tax at 42pc, you should probably not be borrowing to invest in property at all.
Some arguments used against repayment mortgages
The amount borrowed is very high as a proportion of the value of the property.
You should not look at any individual property or individual loan in isolation. Look at your total assets and borrowings. If you have an investment property worth €200k with a €200k mortgage and a home worth €300k, then your loan is only 40pc of your total property.
If you have a mortgage on your home, then you should be repaying the home loan first as the interest attracts little tax relief.
You will still owe the full capital amount in 20 years. With a repayment mortgage, you will owe nothing.
This is misleading. You won't be throwing away the capital repayments you would otherwise have made.
You will presumably be investing them elsewhere. If you have managed to get a return higher than 1.9pc on the money invested, your investment will exceed the value of the mortgage.
Some people with interest-only mortgages don't realise that they will still owe the full capital amount in 20 years time.
Investing in property is a risky business, and people who don't understand the full implications of what they are doing should reconsider whether such investment is appropriate for them.
However, the fact that some people don't full understand a financial product does not mean that it is a bad product.
Interest rates may rise.
Interest rates will rise and fall over the next 20 years. Over the long term, you can expect the return on your investments to exceed the after-tax cost of borrowing.
If there is some long-term change to the investment environment, where you can no longer expect returns to exceed the after -tax cost of borrowing, then you should pay off your loans.
Over the long term, you will pay a lot more interest.
Correct, but you will receive a lot more interest or income on the repayments invested. Repaying a mortgage is a good discipline.
You might squander the capital repayments instead of investing them.
This is not a valid argument against interest-only mortgages. This is an argument against squandering money.
You might invest the capital repayments badly
OK, so a bank might encourage you to take out an interest-only mortgage and to invest the proceeds in a badly-performing tracker bond or endowment policy. This is not really an argument against interest-only mortgages.
It is an argument about investing wisely. It is of course better to pay off your mortgage than to throw the repayments away.
If someone is buying one property hoping it will provide an income when retirement comes around, they best take a repayment mortgage.
Not correct. They will be better off with an interest-only loan if they invest the capital repayments they saved in another investment. Of course, they will be better off if they repay their mortgage instead of squandering the repayments.
Interest-only mortgages are just another form of endowment mortgages
Endowment mortgages were over-sold to people for buying their own homes. They got no tax relief on the interest paid, and the capital which should have been paid off their mortgage was invested in a poor investment.
You are of course better off paying down your interest-only mortgage than squandering your money or investing it badly.
Founder of website askaboutmoney.com BRENDAN BURGESS outlines the arguments for using an interest-only mortgage when buying investment properties
IF YOU are investing in property, you should take out an interest-only mortgage, unless you are not on the top tax rate. In particular, you should always pay off your home mortgage before making any capital repayments against your investment property.
You should borrow the maximum amount possible, bearing in mind the usual warnings about borrowing to invest.
Why?
You can write off the interest against the rental income in calculating your tax. So the real cost of interest is reduced by 47pc. So if you are paying 3.5pc interest, the net cost is only 1.9pc after tax.
Consider the following:
You have a €100k interest-only mortgage and you have a lump-sum of €10,000. Do you pay the €10,000 off the mortgage or do you invest it somewhere else, e.g. an equity fund?
By paying it off the mortgage, you will save only 1.9pc a year. Over the long term, you can expect to get a return well in excess of 1.9pc a year in an equity fund. So you should invest this money rather than pay it off your mortgage.
So you should never pay any capital off a commercial mortgage. If you have a repayment mortgage, you should switch it to an interest-only mortgage.
An interest-only mortgage is even more advantageous if you have scope for contributing to a pension fund. You will get full tax relief on the payment into the pension fund.
The pension fund returns will not be subject to tax. You will get 25pc of the accumulated fund tax free on retirement. You will pay a maximum of 42pc income tax on the balance.
Why are you investing in property at all? The main attraction in investing in property is that you can write off the interest against the rental income. If you are investing money which is not borrowed, you should be investing in equities.
The long term return is higher, the transaction costs are a lot lower, it is easier to diversify, equities are more liquid, and it is a lot less work.
Are there any exceptions?
The main exception is if you are not paying tax at 42pc. Then the tax write-off is worth a lot less. However, if you are not paying tax at 42pc, you should probably not be borrowing to invest in property at all.
Some arguments used against repayment mortgages
The amount borrowed is very high as a proportion of the value of the property.
You should not look at any individual property or individual loan in isolation. Look at your total assets and borrowings. If you have an investment property worth €200k with a €200k mortgage and a home worth €300k, then your loan is only 40pc of your total property.
If you have a mortgage on your home, then you should be repaying the home loan first as the interest attracts little tax relief.
You will still owe the full capital amount in 20 years. With a repayment mortgage, you will owe nothing.
This is misleading. You won't be throwing away the capital repayments you would otherwise have made.
You will presumably be investing them elsewhere. If you have managed to get a return higher than 1.9pc on the money invested, your investment will exceed the value of the mortgage.
Some people with interest-only mortgages don't realise that they will still owe the full capital amount in 20 years time.
Investing in property is a risky business, and people who don't understand the full implications of what they are doing should reconsider whether such investment is appropriate for them.
However, the fact that some people don't full understand a financial product does not mean that it is a bad product.
Interest rates may rise.
Interest rates will rise and fall over the next 20 years. Over the long term, you can expect the return on your investments to exceed the after-tax cost of borrowing.
If there is some long-term change to the investment environment, where you can no longer expect returns to exceed the after -tax cost of borrowing, then you should pay off your loans.
Over the long term, you will pay a lot more interest.
Correct, but you will receive a lot more interest or income on the repayments invested. Repaying a mortgage is a good discipline.
You might squander the capital repayments instead of investing them.
This is not a valid argument against interest-only mortgages. This is an argument against squandering money.
You might invest the capital repayments badly
OK, so a bank might encourage you to take out an interest-only mortgage and to invest the proceeds in a badly-performing tracker bond or endowment policy. This is not really an argument against interest-only mortgages.
It is an argument about investing wisely. It is of course better to pay off your mortgage than to throw the repayments away.
If someone is buying one property hoping it will provide an income when retirement comes around, they best take a repayment mortgage.
Not correct. They will be better off with an interest-only loan if they invest the capital repayments they saved in another investment. Of course, they will be better off if they repay their mortgage instead of squandering the repayments.
Interest-only mortgages are just another form of endowment mortgages
Endowment mortgages were over-sold to people for buying their own homes. They got no tax relief on the interest paid, and the capital which should have been paid off their mortgage was invested in a poor investment.
You are of course better off paying down your interest-only mortgage than squandering your money or investing it badly.
