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Mortgages – to pay off, or not to pay off?

First Published: December 2020 | Available in: Property Articles Your Property Network

By specialist property accountant Stephen Fay ACA

The vast majority of landlords use mortgage finance to build their portfolio, and for most there is a dilemma that at some stage needs to be addressed … should I repay my mortgages in full, and even if I can, is it a good move? Every landlord is different in their financial outlook, comfort with borrowings, willingness to take some risk … and so there is no ‘rule’ as such, more just a number of key considerations, to help YOU make the right decision for YOU.

Why does using mortgage make sense at all? Why not just buy cash and be free of lenders?!

The financial case for using mortgage is well-established – as lenders are willing to advance in most cases 75% of the purchase price of a residential property, this means that a typical landlord can by 4x as many properties than if only cash were used. This therefore means that a bigger portfolio can be built using the same cash pot, and so generate more profit, and hopefully capital gains.

And, the ‘cash on cash’ return (i.e. the Return on (his) Investment, or ‘ROI’) by using mortgage finance is much higher than by using cash only.

This is why BTL has been dubbed ‘the poor man’s private equity’!

E.G.

Mr Nervous has £100k to invest, and buys 1x £100k property, yielding a net (after expenses) 5% profit. His profit is £5k, and his ROI (on his cash invested), is therefore 5%.

Mr Ambitious has £100k to invest, and buys 4x £100k properties, with a 75% mortgage on each property, yielding a net (after expenses) 5% profit. However, Mr Ambitious has to pay the mortgage interest on his 4x mortgages (whereas Mr Nervous is mortgage-free). His mortgages (@2.5%) cost £1,875 per year (£75,000 @2.5%), and so his profit is 4x £5k less 4x £1,875 = £12,500, and his ROI (on his cash invested) is therefore 12.5%

In other words, Mr Ambitious has achieved an ROI of 2.5x that of Mr Nervous, as his ‘reward’ for the sensible use of mortgage finance to buy more property and make more rental profit. If house prices increase – which, is almost a given over the long term – by say 3%, Mr Ambitious will make £12k of capital growth per year, compared to Mr Nervous making £3k per year.

(The above ignores buying costs etc, to illustrate the general point that using mortgages allows for an increased financial result).

So, the benefit of using mortgage finance is (1) to buy more properties than cash alone would allow, and (2) to generate a higher Return on (your) Investment. Tax changes aside, this fundamental to property investing hasn’t changed!

OK, but what factors should I consider when thinking about whether to repay my mortgages?

1. Is your portfolio size at your target level?

Starting to repay existing mortgages while simultaneously borrowing to fund new purchases make no financial sense. In the ‘portfolio build’ phase of a landlord’s property life, using mortgage makes total sense, to acquire property to reach the landlord’s planned portfolio size.

The vast majority of landlords with a significant portfolio size will have started their investing by taking out the maximum value mortgage that each property’s yield would allow, to ‘stretch’ their investment capital as far as possible and acquire the maximum amount of property they can.

These days a word of caution would be around interest rates – as lenders now price very high Loan To Value (LTV) purchases generally much higher than lower LTV, it can make sense to take a medium-LTV mortgage as the sweet-spot i.e. 80-85% LTV mortgage rates are often priced prohibitively high, and 60% LTV mortgages are often very cheap … so the middle ground is often the 75% LTV mortgage, offering a reasonable rate, but still allowing three-quarters of a property’s purchase price to be paid by the lender.

2. How much cash reserves do you have?

Life as a landlord can be financially unpredictable, so having ready cash on hand means property ‘bumps in the road’ can be absorbed without having to resort to selling off property, which as we know is generally an illiquid asset.

There are few problems that can’t be solved by having some cash on hand to deal with the issue – don’t make the mistake of trying to squeeze every drop of financial return from your investable funds, staying in the property game over the years is vital.

Having around £1-2k per property as a cash reserve also provides peace of mind (in many cases, both to the landlords, and their other half!) – if the cash reserve is dipped into, be sure to build it back up.

3. Do you have any non- mortgage borrowings that are a higher priority than mortgages?

Expensive personal loans and credit cards should be the next financial priority – note I specified expensive non-mortgage debt, as some loans and credit cards can be just as cheap as mortgages.

If the answer to all these questions is ‘Yes’, then repaying mortgage debt may be for you.

Paying off mortgages – The Pro’s

Repaying mortgage debt is a safe and sensible strategy to build equity and long-term wealth. The following factors are key considerations:

1. The automatic millionaire

Automatically paying off a mortgage via repayment mortgage requires no effort, it’s just ‘what you do’. You never get used to the spare cash that an interest-only strategy would provide – your reward is a mortgage free property at the end of the mortgage term.

A repayment mortgage guarantees that you will own the property outright at the end of the mortgage term – which then means no interest rate or re-financing worries. What will lender underwriting criteria look like in the future? Will the ‘highest age possible’ reduce so that you can’t remortgage if you’re older – and will you have enough equity to repay the mortgages if you are forced to sell (plus any capital gain tax).

The other option is to pay regular chunks off a mortgage – most lenders allow 10% to be repaid per year – so using rental profits to chip away at mortgages but without committing to a repayment mortgage (which lenders won’t generally allow to be switched back to interest-only).

2. Less debt = higher profits

Lowering mortgage balances will reduce interest payable and so increase cashflow and rental profit. And, as a lower LTV means less risk for a lender, a landlord can benefit from lower interest rates, as a result of a lower LTV.

And, by paying off individual mortgages one at a time, extra flexibility can be achieved as unencumbered assets can be used as security for bridging and similar short-term borrowings, allowing a landlord with some unencumbered property to pounce on a good new deal by leveraging an unencumbered property.

3. If mortgages bother you, that’s fine

There is an emotional element to all business, and as we get older we tend to want more security. There is also something very satisfying about owning property outright – who is to say that’s ‘wrong’ – it may not be what the next landlord would do, but it’s your property business and you can decide what your preference is.

Paying off mortgages – The Con’s

1. Mortgages rates are at an all-time low (especially low LTV mortgages)

Many landlords are still on their first mortgage on a property, which has reverted to a cheap pay rate as the mortgage tracks the Bank of England Base Rate (or LIBOR) – these “liabilities” are now more like assets!

And, modern mortgage rates are also at a historic low e.g. TMW 65% LTV single-let 5-year fix of 1.64%. Paying off such a mortgage, compared to retaining it, means the landlord is effectively accepting an ROI of 1.64% on the amount repaid – surely a decent property investor can do better than that!

2. Cheap, sensible mortgaging means more profit and properties

If using debt finance is good enough for private equity firms, it’s good enough for private landlords!

Don’t forget the number 1 goal of property investing … to make rental profits and capital gains. Mortgaging property allows more property to be acquired, to generate positive cashflow and capital growth.

And, the goal is to become financially-free, not mortgage-free. Most big companies acquire other companies via a mix of debt and equity because they want to preserve cash – the goal of most large companies is not to pay off all their borrowings, it is to strategically use borrowings to build up the business and so make more profit.

3. Is your spare profit and cash better spent differently?

Many landlords have modest property plans (e.g. a very common target is to have 10 properties going into retirement age). It may well be that there are better uses for any spare cash e.g. spending on property repairs and upgrades could enable a higher rent to be charged. Just £2k spent on repair works could easily improve the rent by £25-50pcm – an annual return of 15-30% on funds spent.

All properties need a certain amount spent on repairs just to maintain the property – but could investing in the fabric of the building (windows, roof, boiler, kitchen, bathroom, small structural changes) mean lower future repair costs and higher rents, which could result in a higher ROI on the funds?

4. Capital growth happens whatever the LTV

Equity in a property has no effect on the appreciation that a property may show – the property may be unencumbered or at 150% LTV – the appreciation will happen (or not), either way. Given that most investors’ primary aim to benefit from capital appreciation over the long term, it therefore makes less sense to repay debt that can be comfortably serviced.

5. An offset mortgage saves the interest but keep the cash reserve

Modern offset mortgages allow cash savings to be offset against a mortgage balance to reduce the interest payable, but while retaining access to the cash (note: this is guaranteed, unlike some old products where the lender could withdraw the facility on a whim).

So, don’t commit to a repayment mortgage, remortgage the property onto an offset mortgage– and ‘park’ spare cash into the offset facility. This means the overall interest payable reduces, with no loss of liquidity. There are even BTL Offset Mortgages available e.g. Family Building Society, Hinckley Building Society (although generally offset mortgages are for private residence property).

6. Life is unpredictable – don’t give lenders the upper hand!

Unemployment, a failing business, or an unlucky streak of voids and repairs, can all put pressure on cashflow and the cash buffer. Insurance companies plan their cash reserves with an ‘every 100 years’ event in mind (volcano, tsunami … pandemic!).

It’s fairly predictable that during a typical 25-year mortgage term there is likely to be a event, or a series of issues, that could cause a ‘cash crunch’. Your mortgage lender is not going to congratulate you for your prudence in repaying capital and happily allow you to re-borrow it on the same terms – nor is the lender likely to want to lend you funds while you are jobless or struggling!

Summary

Most landlords build up their property portfolio by maximising mortgage borrowings in their early ‘portfolio build’ years, then reach a target portfolio size and made a conscious decision to not buy any further property (bar the odd purchase or sale), and then face the classic dilemma … should is pay off my mortgages?

For many landlords, repaying more expensive non-mortgage debt, building up a decent cash buffer, and investing into the fabric of their buildings, should be a priority over repaying routine BTL mortgages.

Once a well-maintained portfolio has been built up, and good cash reserves are in place, the focus should then be on ensuring that the LTV on each property achieves the lowest possible mortgage rate

e.g. paying a mortgage down from 68% LTV to 60% LTV, thereby allowing the mortgage to be refinanced onto the cheapest possible rate, will result in a very high ROI on the 8% cash required. Whereas, paying the mortgage down below 60% LTV results only in an ROI of whatever the 60% LTV mortgage rate is – which is often pretty low. In other words, strategic repayment of mortgages is a better plan than simply sprinkling money evenly across several mortgages with no strategy to ensure a good ROI is achieved.

Ultimately, we are all different as landlords, and what may be “spreadsheet-optimal” for me, may not be what is “emotionally-optimal” for you … more than ever though, in this day and age, people are free to do things their way, and that can’t ever be a bad thing.

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