Property investors with capital repayment mortgages are surprised to learn that they cannot deduct the mortgage payments in full when working out the income from the property for tax purposes.
They can however deduct the mortgage payments in full on interest only mortgages. So clearly interest only mortgages are more beneficial for property investors.
There are 2 clear concepts to understand the reason for this situation.
The anatomy of a mortgage payment
The concept of a capital repayment mortgage is that over the life of the mortgage, it is gradually paid back, so that at the end of the term which could be 5 years, 10 years or 30 years the loan is fully repaid and the property is owned outright.
Interest is charged on the outstanding balance each month, so the borrower needs to pay that month’s interest, plus an extra amount to pay off some of the original loan amount. This extra amount is called the capital repayment.
The total monthly payment tends to stay the same throughout the life of the mortgage and it is calculated to pay interest and capital so that no capital repayment is required at the end of the term.
With interest only the loan amount stays the same at the beginning and the end of the loan but the value of the property should have increased.
Tax difference between a payment and an expense
For accounting and tax purposes there is a big difference between a payment and an expense.
In simple terms, a payment is when you convert money into something else you own, that does not leave you any worse off overall. For example, suppose you pay £15,000 for a car. Yes, you have now got £15,000 less in the bank, but instead you have now got something else worth £15,000. Overall you are no worse off.
An expense is an event that does leave you worse off. After a year of use, that car would have lost some of its value. That depreciation is an expense, along with the petrol used and repairs carried out.
The tax system generally only gives tax relief for expenses, not payments, since it is only expenses that leave you worse off overall.
In terms of a mortgage, the capital repayment part of the monthly payment is paying off the borrower’s debt. As the debt has gone down by the same amount as the capital repayment part, there is no overall loss on that element, and so no relief is available. By contrast, the interest element of the payment has no corresponding benefit, so it is a loss which can be deducted from rental income.
Other considerations for interest only mortgages
Property investors are generally trying to reduce the monthly operating costs and increase the monthly income via rent. An interest only mortgage should always be a lower monthly amount than capital repayment because your only paying the interest and the loan amount remains the same.
Property investors expect their holdings to appreciate and potentially double in value over 10 years so even though they still owe the full mortgage amount they have more than twice that in equity.
Now imagine you want to progress into a 10 holdings portfolio at this level – you are looking at sizeable equity exit. As long as you can secure the funding to start with its easy to see why more and more people and businesses are getting into the property investment market. You simply cannot get the scale of return from savings accounts.
Any loan must be serviceable for the lender to approve in the first place. Therefore interest only gives you the ability to service a higher amount of debt and with terms from 10 years to 30 years the payments could be surprisingly cheap compared to capital repayment.
Interest only mortgages in the property investment sector is a specialised product and only available from a select number of lenders who are actively seeking to increase their loan book in this area. It is not a traditional space for retail banks to operate. Some lenders even offer an interest only with the option to repay capital at the same time.
For a free property portfolio review and assessment please contact us, you may be able to reduce your monthly costs, reduce your tax bill and release more funds for new projects. It costs nothing to find out.
We always advise our clients to seek financial advice from their accountant. Tax law in relation to buy to let mortgage landlords has changed and clients may want to consider incorporating. Every clients circumstance is different and there are numerous and variable contributing factors to consider. Please seek professional accountancy advice before applying for a mortgage.