FOOL'S EYE VIEW
Solving The Mortgage Conundrum

By James Carlisle
February 4, 2002

Great Titchfield Street, London -- All mortgages charge you interest as you go along, but they can differ as to how you repay the capital. With a 'repayment mortgage', you repay a bit of the capital each month, so that it eventually reduces to zero over the life of the mortgage, whereas with an interest-only mortgage you put money into investments every month (an ISA being the obvious choice), so that at the end of the mortgage, you can pay it off in one fell swoop.

There has always been plenty of debate about which of these approaches is best (most of the arguments are made this thread, kicked off by this article), but I don't want to get sucked into that. In any case, there is less difference between the two approaches than people imagine. The mechanics of a repayment mortgage means that the size of your mortgage only really starts to fall quickly towards the end. So, whichever route you go for, you're going to be taking on a large slab of debt for a very long time.

This fact presents us with a lot of risk, but mortgages also provide us with the potential for major rewards. Without mortgages, few of us could buy our homes and, over the long-term, this has generally proved to be a profitable thing to do. Mortgages can also magnify this effect through 'gearing'. If you have a risky but profitable game to play, then the way to tip the odds in your favour is to make sure you can play it a lot of times. In the case of mortgages, that means making sure you can stick with them and continue to make the payments for their full term (or even more).

The mortgage conundrum

Here's where we get to our mortgage conundrum. If we want to be sure of making our mortgage payments, then we really need to have a stash of 'rainy-day' cash tucked away, just in case interest rates rocket or our work goes through a lean patch. The trouble is that this cash won't be earning as much interest as we're paying on our mortgage. Not only that, but unless your cash is in an ISA (and using up your precious annual ISA allowance), then you'll have to pay tax on the interest it does earn.

The bottom line is that it's very inefficient to have cash sitting around while you're simultaneously paying interest on a mortgage, yet that's just what you have to do to control your risks.

The solution - current account mortgages

The solution is provided by the new 'current account' mortgages. These basically work by having your mortgage debt in your bank account as one whopping big overdraft. Say you buy a house for £100,000, with a mortgage of £90,000 and a deposit of £10,000. You'd start off with an overdraft/mortgage of £90,000 on which you'd pay a typical mortgage rate of interest. Each month your salary goes into the account, expenditure goes out again, and anything left in the middle will go to reducing your overdraft/mortgage.

The trick is that if you can manage to reduce your overdraft/mortgage to, say, £80,000, you'll still have a borrowing limit of, say, £90,000 (depending on the terms of the mortgage). So, you've effectively got yourself a £10,000 stash of rainy-day cash without actually having to have any cash sitting around. There are several advantages in doing things this way.

Lots of positives

1. The interest rate you get on your (pseudo) stash of cash is automatically the same as the interest rate you pay on your mortgage (because you're saving yourself the mortgage interest). No deposit account will be able to match that sustainably (even if they might have artificially high rates for short periods in an attempt to boost market share).

2. The few pounds that you might otherwise have sitting around in a low-interest current account (say before you move it over to your deposit account) will automatically earn you interest at the same rate as you're paying on your mortgage.

3. So long as you get yourself a decent buffer, you'll avoid slipping accidentally into a real overdraft that'll carry a punitive rate of interest and possibly bank charges.

4. Because you're actually reducing the interest you pay instead of earning any, there's no tax to pay. So you're effectively saving your cash tax-free, but it's more efficient than using an ISA (giving you a better rate of interest) and means you can save your annual ISA allowance for stock market investments.

5. The final benefit comes from the flexibility to repay your mortgage as quickly or slowly as you like, and get the right balance between this, your emergency reserves and your stock market investments to match your individual circumstances and tolerance of risk.

And a couple of negatives

There are, as ever, a couple of downsides. To start with, there is a limited market for these products at the moment and that means that they don't have the most competitive interest rates on the mortgage market. This is likely to improve as the products become more popular, but it's unlikely that they'll ever be the cheapest mortgages on the market, because you'd expect them to be more expensive to administer.

The biggest problem, though, comes down to discipline. If you can borrow money cheaply, then there's the risk that you'll just keep doing so and never actually have that emergency reserve and never actually pay off the mortgage. If this sounds like you, then a repayment mortgage is the only answer, since it forces you to pay back the capital.

More good than bad

If you have the discipline (touch and go for me, but that's another story), then I'd say there's more to gain from current account mortgages than there is to lose. At the moment, I'm three years into a five-year fixed rate mortgage, but I'll most likely switch over to a current account mortgage as soon as I can.

Learn more about mortgages in the Fool's Homeowning Centre