There’s three common ways of financing a property investment, each of which depend on many factors including: the time you’re looking to spend in the market, the returns you’re looking to achieve, your personal aversion to risk and current cash flow position.
Below we examine these three common methods of financing and how you can use them in your own strategy.
As always, we’re not financial advisors and it’s important to speak with a financial advisor or investment expert before you start your property investment process.
Capital and Interest Mortgage (Repayment)
This type of mortgage, sometimes referred to as a Repayment Mortgage, is when the investor pays back both the capital and the interest during their mortgage term, with the view of fully owning the property at the end of the repayment period. This type of mortgage will cost more month-to-month than an Interest Only mortgage.
Typically, this type of mortgage requires a more ‘cash liquid’ position, as it’s likely that your rental returns won’t cover the larger mortgage repayments and you’ll be expected to make small contributions.
An interesting way of looking at this is considering these contributions as similar to those you’d make to a pension, which increases in value alongside your capital growth.
While this means returns are initially low, this type of financing does offer the strongest ROCE (return on capital employed) over the long-term – particularly at the end of the mortgage period – as you’ve essentially been building equity while paying your loan and interest.
When all is said and done, you’re left with a property that is fully paid off, has hopefully accrued capital growth and can also still offer rental returns, all of which are entirely profit.
Challenges with this type of financing mainly revolve around it’s lack of flexibility when it comes to voids or maintenance issues. Because your rental returns will typically go towards paying the mortgage, there’s little opportunity to build a ‘rainy day fund’ to deal with issues that may arise, which could see you paying out of your own pocket.
+ Strongest Return on Capital Employed
+ Build equity & maximise returns over the long term
– Lower rental returns during the repayment period
– Less flexible than other options
Interest Only Mortgage (Halfway House)
Typically the most popular financing option, an Interest Only Mortgage is a flexible option for those that are looking for higher rental returns during the repayment period.
With this type of mortgage, investors pay off the interest on the mortgage each month but don’t pay off any of the loan – that’s left until the end of the repayment period when it’s paid off in full. This means month-to-month payments in an Interest Only mortgage will be less than those in a Repayment mortgage.
The loan is usually paid by the investor either remortgaging for leverage, selling the property and taking the capital growth or paying it off in cash.
While this means you lose out on building equity within the investment, it does offer a positive net cash flow position from the outset, providing you with small to moderate income each month depending on your yields. This is why it’s often described as a ‘halfway house’.
This financing option is usually chosen by someone that doesn’t necessarily have the liquid cash or assets to fall back on, as the higher income each month allows them to build a financial safety net to deal with voids or emergencies that arise.
At the same time, this type of financing option is popular with those that are looking to scale their investment over the long-term.
An Interest Only mortgage offers the most flexible investment position out of the two common options but won’t be able to match the long-term overall returns of the Repayment mortgage.
+ Most flexible investment finance option with moderate rental returns
+ More opportunity to build a financial safety net and scale a portfolio
– Can’t match long-term returns of a Repayment mortgage
– Loan payment required at the end of the mortgage term
The final financing option in our list is relatively simple – paying upfront with cash.
Mainly chosen by those that are cash rich (not a surprise), this type of financing option is suited for investors that want to achieve immediate passive income and a much higher positive net cash flow position in the short-term.
As you’d imagine, it also removes the need for a mortgage, which can make it popular with those that are looking to invest quickly or want a more ‘hassle-free’ experience.
Typically, this option is ideal for those that have a lump sum earmarked for investment and want to use the property as an income generator.
While a cash investment offers the best returns in the short-term, it offers the lowest ROCE (return on capital employed) out of the three options, purely because of the large investment upfront. This doesn’t mean you lose out on growth, it’s purely based on the initial outlay.
A cash investment can be considered as being similar to investing in a financial market, where your rent is the dividend paid out. The only difference is, property is typically a much more reliable, stable and proven asset that is less complicated for most investors.
For investors that may be looking to use property as a pension fund, or even build an inheritance plan to maximise capital growth, a cash investment can be an excellent alternative.
+ Exceptional returns in the short-term
+ ‘Hassle free’ option with full ownership on payment
– Lowest Return on Capital Employed due to initial outlay
– Least accessible financing option
The difference between Interest Only and Repayment Mortgages
Both Interest Only and Repayment mortgages are viable options for those investing in a Buy-to-Let property. Repayment mortgages are where the investor pays back both the capital and the interest, with a view to fully owning the property at the end of the repayment period. These types of mortgages will cost more month-to-month than an Interest Only mortgage.
While this can mean lower returns at the start of the process, by the end, the investor owns the property and all rental returns will be entirely profit.
Interest Only mortgages work exactly as they sound. The investor will take out the mortgage but only pay the interest on the mortgage from month-to-month.
As you’d imagine, the monthly payments are lower (which typically means you’ll have more rental returns to play with) but none of the capital is paid off in the process – it must all be paid back at the end of the mortgage term.
Is an Interest Only or Repayment Mortgage Best for Buy-to-Let?
Financing a Buy-to-Let investment is one of the more important choices to make at the start of your investment as it can determine your overall strategy. Different mortgage rates can add up over an entire investment period so it’s important that you get both the right support and the right product.
This invariably leads most investors to a common question: do you choose an interest-only or repayment mortgage? Typically, landlords with a bigger portfolio will use an interest-only mortgage to finance their investment as they’re more flexible.
With lower overheads then a full repayment mortgage, this makes it much easier to expand your portfolio and finance new properties. That said, a Repayment mortgage offers a much better ROCE (return on capital employed) than an Interest Only mortgage over the long-term and will largely be chosen by those that want to maximise a long-term investment.
While this may require a more liquid position, the larger month-to-month payments of a Repayment mortgage can be viewed as a ‘pension contribution’ while you’re building equity and benefitting from capital growth.
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