What is wrong with interest-only mortgages for investment properties?

[Brendan Burgess]

Michael McGrath has criticised ICS's new interest only mortgages for buy to lets.

Central Bank cannot ignore risks in 15 year interest only mortgages - McGrath

Deputy McGrath commented, “In recent days, I have highlighted the fact that buy-to-let mortgages are now being offered by ICS Mortgages with an initial interest only period of up to 15 years. The overall term of these loans is up to 35 years with a maximum borrower age on maturity of 75. The lender does not require a life policy to be assigned for a buy-to-let mortgage. The interest rate on an interest only loan with an LTV greater than 50% is 5.45%.

“This form of lending is not a sustainable funding basis for the rental sector and poses risks for the tenants that depend on a stable rental market. The product also carries very serious risks for borrowers and their families. Experience tells us that property prices, rental yields and interest rates all fluctuate – sometimes dramatically. An investment that might seem like a sure thing can and has turned into a nightmare for many. Residual buy-to-let debt becomes personal debt and can ultimately be attached to the family home of the borrower as a judgment mortgage.

Here is a summary of the ICS Interest Only Product

Mortgage rate: 5.45% for loans from 50% to 70% - the maximum LTV
Mortgage rate: 4.95% for less than 50% LTV
Maximum term: 15 years

Property investment is risky in itself

Property investment is risky in itself. Property prices can fall over the long-term. Rents may fall or there might be a prolonged period of no rental income.

Borrowing to invest in property increases the risk.

Borrowing at 5.95% to buy a residential property increases the risk even further and probably makes it a stupid investment.

But these risks are not increased by the fact that it is interest only

Assuming the same interest rate, which is riskier - a 100% LTV capital and interest loan over 30 years or a 50% LTV interest-only loan over 15 years?

It will take 20 years for the 100% LTV loan to amortize down to 50% LTV - assuming prices remain the same.

As a lender, I would far prefer to give out a 50% LTV interest-only loan.

It could be argued that interest-only reduces the risk to the borrower

A capital and interest loan of €100k over 15 years at 5% has repayments of €790 compared to an interest only repayment of €416.

Clearly,the borrower who is on interest only is less likely to default.

I am not arguing that people should not pay off the capital on their loans

As I don't think it makes no sense to borrow money at 5.95% to invest in property, I would also argue that anyone who is paying that rate, should aim to pay down their mortgage.

 

[Brendan Burgess]

The crazy lending practices during the Celtic Tiger years should not stop sensible practices now.

A friend of mine bought a 3 bed house as an investment for €1.5m around 2006. He borrowed 100% at around 5%. He rented it out at €24,000 a year. (This was part of a much larger portfolio)

I told him that it made no sense to be paying €75k interest and only collecting 1/3rd of it in rent.

He may well lose his family home as Receivers have been appointed to most of his investments.

But this type of carry-on has been stopped by the new Central Bank rules which allow a maximum LTV of 70%.

If a lender were prepared to charge a rate of 3% interest-only on a 70% LTV buy to let, it would probably be viable.

The interaction of mortgages on family homes and on investment properties

I have argued, that if someone has a mortgage on their family home at the same interest rate as that on their investment property, they should pay off the family home mortgage first.

 

[cremeegg]

A very timely post so far as I am concerned.

The paperwork to apply for one of these loans just arrived in my inbox.

Here is my thinking on the issue of funding buy to lets through this type of lending generally and looking at my own example.

The property I am looking at will cost approx €200k and yield approx 10%. That is rented to sharers, requiring a bit of effort. Effortless (you hope) renting to a family would yield about 8.5%

The property is an ex council house, convenient to a university and hospital so should always have a supply of tenants. It is also convenient to shops, busses, schools etc. The area certainly had a reputation as a bit rough in the past but realistically nowadays has no more problems than anywhere else.

The property is suitable for use in letting long term. There will always be people coming to the hospital or university for a few years who want to rent and not buy. They will always be interested in a place where they can walk to college or work and to Dunnes, Lidl and even to Mass. There is little or no prospect of either the university or hospital closing, the area is already well built-up so little prospect of large scale new development.

Costs of letting including a charge for renovations, will come to no more than €2k per annum, so my 10% becomes 9%.

A long term IO loan to fund this makes perfect sense. Interest is a cost of a rental business. While the landlord is entitled to a profit, under the traditional model the cost of capital repayments, are in effect passed on to tenants. (Think this is similar to the point made by The BS on an other thread) That is hardly reasonable on the tenant, and in effect it requires the landlord to plough his profits back into repaying the capital, maybe he would prefer to spend his profits some other way, and why shouldn't he.

My 9% yield now needs to cover the interest 5.45%, so I am left with 3.55%. However due to the restriction on interest expense, the taxman looks at this as 4.64% profit. Given that I am a higher rate taxpayer that means the taxman wants 2.32% leaving me with 1.23% (The reader may multiply these per centages by 2,000 to convert to Euro if that seems easier).

My conclusion, the return is very low for the effort involved. The main problem is that the tax is too high, don't forget that over half of every Euro paid in rent goes to the tax man. (Certainly for a new buy to let. There may be historic landlords who aren't paying 50% tax but no one getting a BTL mortgage today is.)

Of course a low return is to be expected. ICS no doubt have calculated the rate so that they capture as much of the yield as possible.

If the market thought that the interest rate was low and that there was good profit to be made, the price of the BTL property would go up.

No sensible person would take up a BTL at these rates unless they thought that property prices were going up, or rents were going to rise, or that they could remortgage at a much lower rate in the near future, or for some other reason outside the normal letting business case.

 

[Brendan Burgess]

Excellent post cremeegg

Just one question- I don't understand this point and I very much doubt that The BS said this:

While the landlord is entitled to a profit, under the traditional model the cost of capital repayments, are in effect passed on to tenants.

A tenant pays the market rent. A landlord charges the market rent. If you have a 100% mortgage on your property and I own the one next door mortgage-free, you can't charge a higher rent just because you have capital repayments to make.

 

[cremeegg]

A tenant pays the market rent. A landlord charges the market rent. If you have a 100% mortgage on your property and I own the one next door mortgage-free, you can't charge a higher rent just because you have capital repayments to make.

Of course that is true, yet every business seeks to recover their costs, and landlords usually include the capital cost of the property in the costs they seek to recover. The traditional Capital and Interest mortgage promotes this.

As regards TBS, I certainly do not want to misrepresent anyone, (especially any one as big as TBS ) there was a thread where he was proposing an alternative model of financing private sector rental, which I understood to be based on the idea that tenants should only pay the cost of occupying a property not the cost of owning it.

 

[blured]

The property I am looking at will cost approx €200k and yield approx 10%.

My 9% yield now needs to cover the interest 5.45%, so I am left with 3.55%. .

Just on this - the interest is only going to be on the loan, assuming you don't have a 100% Interest Only BTL

 

[IdesofMarch]

Caveat emptor springs to mind. Dilosk's underwriters are happy to underwrite the product (which will be immediately securitised)

 

[Andy836]

Interest only mortgages are a great idea.
It levels the playing field between REITs / Institutional Investors and regular joe soaps.
That is, provided the LTV is low enough to pass through a downcycle.

 

[llgon]

The main problem is that the tax is too high, don't forget that over half of every Euro paid in rent goes to the tax man.

In your example are you not looking at approx. 25c in every euro of rent received going in tax?

 

[Gordon Gekko]

A pal of mine has an old LTV Mortgage with Pepper at the ridiculously low rate of 0.50% (i.e. ECB+0.50%). There are about 15 years left on it and there’s about €150k outstanding on a property worth around €300k.

He’s toying with the idea of remortgaging for 15 years interest only. My initial reaction was that it would be a crazy think to do; however, his plan is to make AVCs which he would otherwise be unable to do. The headline interest rate isn’t great, but because it’s a rental property, the payments are deductible, which effectively halves the rate (once full deductibility has been phased back in).

Borrowing at (say) 2.5% to fund AVCs for 15 years might make sense.

 

[Brendan Burgess]

So he is swapping a 0.25% net loan with a price promise for a 2.5% net loan with no price promise.

Doesn't sound right at all.

But it's interesting that this might make the interest only attractive.

Brendan

 

[Gordon Gekko]

So he is swapping a 0.25% net loan with a price promise for a 2.5% net loan with no price promise.

Doesn't sound right at all.

But it's interesting that this might make the interest only attractive.

Brendan

It doesn’t sound right at all; however, in the absence of doing this, he can’t make AVCs with the capital repayment element of the mortgage. Borrowing at 2.5% to invest in one’s pension (provided the asset allocation is appropriate) over a 15 year period probably isn’t the worst idea in the world. I need to run the numbers; it might just be something that appears crazy but is in fact reasonably astute.

 

[cremeegg]

In your example are you not looking at approx. 25c in every euro of rent received going in tax?

Yes of course you are right, I should have said, over half the rental income after allowable tax deductions goes in tax. However as part of the interest and certain other costs are not allowed as deductions, the effective tax rate can be very high.