Buying outright vs. Interest Only Mortgage - Am I overcalculating?

trelloskilos

Hi all

Apologies for duplicating this post. I originally posted it in the "Mortgages" section of the MSE forums, but felt it was more suitable to this section.

I've been trying to do the maths on this one, and either I'm overlooking something, or my initial preconceptions that buying outright is more profitable than getting a mortgage, are completely wrong.

I've simplified the figures below, a little, and not taken into account various fees (solicitors fees, service charges etc., but I believe the principles are still the same...!)

Here's my situation:
I have found a property that I can buy for £100,000. I intend to buy it for the purpose of renting it out. My research has led me to expect £750pcm (£9000 per annum) for the property.

Assuming I just buy the property outright, and later, sell on, I could expect a % return on my initial investment of 9% per annum (not counting additional solicitors fees, service charges etc.)

That's quite a good return, but I was looking at getting an interest-only buy-to-let mortgage at 4%, with an initial outlay of £30000

So, basically, my mortgage would be for £70000. The mortgage company would expect me to pay £2800 per annum

This would mean that my initial outlay of £30000 would see a return of £6200 (the £9000 annual rent minus the £2800 to pay the mortgage)

By doing this, my % return with a much smaller outlay would seem to be much larger! Roughly 20.6%!!!!!

If I used my £100,000 to buy the one property outright, I would end up with £9000 per year. But if I used that £100,000 to get 3 identical properties, each with an outlay of £30,000, and a 5% interest only mortgage, and recieve identical rents, I could end up with potentially £18,600 per year, and still have £10,000 left in the bank!

Either I've worked myself into a financial equivalent of that old maths chestnut about the 3 men and the £25 hotel room, or the maths is sound, and I would be better off getting the mortgage than buying a property outright!

Is my maths sound? Is this how budding property developers and landlords work? Or have I got something horribly wrong?

I've spoken to brokers, agents etc., and I either seem to have flummoxed them, or they have responded "I never thought of that!". But if it's feasable to use a buy-to-let mortgage in this manner, and the maths is sound, why aren't more people doing it, and most importantly, where is the catch??

I know this is hypothetical, and the figures are not strictly accurate, but rounded up for clarity, but in a real-world situation, are there any other risks I should be aware of?

Many thanks for your help!!

House_owner

Surely you will need to put aside money to pay off the capital on your interest rate mortgage - so you need to factor this in as well

Egg_custard_2

Paying off the capital at some point is one issue. There's also an added risk if you take on higher borrowing that increases in interest rates will reduce your net profit. Also if the place(s) doesn't let, you will have created an outgoing (the mortgage) that you will need to cover from other income sources.

Caveat_Mortgagor

Its called leverage.

Many people became 'heavily leveraged' when the market was climbing.

The rewards can look juicy if you keep one eye closed.

But the more you are leveraged, the more susceptible you are to falling asset values.

If you buy 1 house outright, the housing market would have to fall 100% for your equity to be eroded.

If you split your hundred grand 3 ways and borrow the rest, a 33% fall in the market would erode all your equity.

If you split 10 ways, a 10% fall will burn your hundred grand.

Some people will value the income ahead of the the asset value, others will place more value on building equity. You have to make the choice that suits you.

trelloskilos

Thanks for the replies so far.

With regard to the paying off the capital, I just want an interest-only mortgage. I'm not looking to become the property owner outright long-term, but I wanted to use the property to generate an income, and sell on in the short-to-mid term.

If I'm able to sell off the property at the same amount as I bought it, I could clear up the mortgage quite easily....couldn't I?

HappyMJ

If you can find a property for £100,000 with a monthly rental of £750 you are already onto a winner there. Are you sure the property will get £750 per month. Sorry but around here using LHA rates and average property prices from zoopla. (which I do admit are not entirely accurate but they are close)
1 beds are worth £80k rent for £370 per month.
2 beds are worth £110k rent for £450 per month.
3 beds are worth £130k rent for £495 per month.
4 beds are worth £170k rent for £695 per month.

abankerbutnotafatcat

One of the fundamentals of corporate financing is which mix of capital and debt to choose. There is no right and wrong - both have advantages and disadvantages and your own attitude to risk is a big consideration. Plus, given the lessons of recent years you are unlikely to find a lender at the moment who will allow you to repeat some of the mistakes of over-gearing caveat mortgagor has pointed out.

One major reason why some people choose the debt route is that interest is tax deductible. Not sure if you've factored this into your calculations.

You can plump for a 'best of both worlds' capital and interest i.e. repayment mortgage? Taking advantage of the tax advantages of debt whilst still conservatively paying back some of the capital? HTH Good luck

trelloskilos

HappyMJ wrote: »

If you can find a property for £100,000 with a monthly rental of £750 you are already onto a winner there. Are you sure the property will get £750 per month. Sorry but around here using LHA rates and average property prices from zoopla. (which I do admit are not entirely accurate but they are close)
1 beds are worth £80k rent for £370 per month.
2 beds are worth £110k rent for £450 per month.
3 beds are worth £130k rent for £495 per month.
4 beds are worth £170k rent for £695 per month.

Thanks for the response. I'm based close to London, and the property is on the outskirts. I guess that rental costs vs. the properties values will vary around the UK.

Also, please bear in mind the figures I used were hypothetical & rounded up, and down, but even if you plugged in the figures for an £80k 1 bedroom flat for £370, with a 5% interest only mortgage, the outcome is still the same....namely that reducing the outlay, using the rent to pay off the interest on the mortgage (and ONLY the interest), sees a much better percentage return than buying outright.

HappyMJ

trelloskilos wrote: »

Thanks for the response. I'm based close to London, and the property is on the outskirts. I guess that rental costs vs. the properties values will vary around the UK.

Also, please bear in mind the figures I used were hypothetical & rounded up, and down, but even if you plugged in the figures for an £80k 1 bedroom flat for £370, with a 5% interest only mortgage, the outcome is still the same....namely that reducing the outlay, using the rent to pay off the interest on the mortgage (and ONLY the interest), sees a much better percentage return than buying outright.

I see where you are coming from so the £20,000 required to buy the £80,000 flat would effectively return 7.2%. Only deducting the interest payable from the rent recieved. Property doesn't have gas so that's a bonus. There is ground rent/maintenance fees to pay which I think is only about £360 per year so the return is still good. I would always suggest getting a buy to let mortgage as the interest payable is deductable from the income recieved and will save you tax even if you still had the money in the bank elsewhere maybe in a partners name on which they either don't pay tax or paying it at 20% rather than 40%. There's a few options and I wish you luck. I didn't know that property was so cheap on the outskirts of london.

trelloskilos

HappyMJ wrote: »

I see where you are coming from so the £20,000 required to buy the £80,000 flat would effectively return 7.2%. Only deducting the interest payable from the rent recieved. Property doesn't have gas so that's a bonus. There is ground rent/maintenance fees to pay which I think is only about £360 per year so the return is still good. I would always suggest getting a buy to let mortgage as the interest payable is deductable from the income recieved and will save you tax even if you still had the money in the bank elsewhere maybe in a partners name on which they either don't pay tax or paying it at 20% rather than 40%. There's a few options and I wish you luck. I didn't know that property was so cheap on the outskirts of london.

Well, £20,000 outlay on an £80,000 flat would still need a £60k mortgage. - Assuming I have my 5% interest only, buy-to-let mortgage in place, and at a rent of £370 per month (or £4400 annually)...

Then buying outright would leave me with £4400 from an £80k investment (in other words, a 5% return on my initial investment of 80k)

Whereas getting the 60K mortgage would mean my initial investment is only £20K. The mortgage company stump up the rest, on the condition that I pay them £3000 a year. This would leave me with only £1440 after the mortgage payment is deducted from the rent, but the return I'd get is 7.2% from my initial outlay of £20,000

If I repeat this 4 times, & get 4 identical properties with identical rents and identical mortgages, at £20K outlay each time, then my £80K would end up netting me £5760 instead of a comparitievly measly £4400

That's still a better return than buying outright....! Right?

Logically, it seems to work, but I really just want someone to look at the maths and either say "Yep, it's sound", or "No, you're being stupid. You've got it all wrong!"

Thanks HappyMJ and everyone else, for your inputs so far...!!

Also, I do understand that renting properties will incur additional expenses, solicitors fees, surveyors fees, ground rent, service charge, ongoing maintenance etc. - The reason that I have not included these additional expenses into the hypothetical situation I outlined in my original post, is that these are expenses that I would have to consider, regardless of whether I bought outright, or whether I secure a mortgage, and I just wanted to keep the example as clear as possible

HappyMJ

You are right. Risks are multiplied if the property market goes down but returns are quadrupled if prices go up. Risks are divided if the property is empty. Assuming only 1 of your 4 will ever be empty at once at least you'll still be getting 75% of the rent. I'd still like to find a property for £100k with £750 return. Thats really good. I think you understand the maths but remember to use actual real figures and not too much rounding. If the average rent in your area is £750 is that for a property of the style that you are looking to buy. I tend to use LHA rates to find average rents and work from there. Returns (percentage wise) tend be higher on cheaper properties.