FOOL'S EYE VIEW
The Risks Of Interest-Only Mortgages

By James Carlisle
August 28, 2002

One of the hottest debates in the dynamic world of mortgages is about whether people should opt for a 'repayment' or an 'interest-only' mortgage, but it makes less difference than people would have you think. It's far more important to stick to the basics: don't overstretch yourself with your mortgage and save hard!

How they work

The difference between repayment and interest-only mortgages is that, with the former, you repay a little bit of the capital each month so that it gradually reduces and, by the end of your mortgage term (normally 25 years), it's totally gone. With an interest-only mortgage, as you might guess from the name, you just pay the interest each month. So the capital that you owe doesn't reduce. Instead, you build up a pile of investments that you hope will be enough to repay the mortgage at the end of its term.

We can flesh it out with an example. Imagine that you buy a £100,000 house and take out a £100,000 mortgage (although whether you can or should get a 100% mortgage is another matter). We'll also assume an interest rate of 6% over the 25 years (charged monthly).

The monthly payments on a repayment mortgage would be £634.62. That's initially made up of £486.76 interest and a capital repayment of £146.87, though the former will gradually decrease, while the capital repayment gradually increases.

With an interest-only mortgage, you will start by paying the same £486.76 of interest (since you owe £100,000 just as you did at the beginning of the repayment mortgage). But this time, it doesn't go down so you keep paying £486.76 every month until the 25 years are up. That's £146.87 less than you pay on the repayment mortgage, but you'll still be saddled with the £100,000 debt after 25 years. So you need to do some investing over the years to come up with the money to pay off the mortgage.

The neat thing is that if you invest the same amount that you're saving on the mortgage payments, that is £146.87, and you get an investment return (after tax and charges) that matches the interest rate you pay on the mortgage, then you come out exactly quits. That makes perfect sense, because the money you're paying into the investments is money that you haven't repaid on the mortgage and that money (that you haven't paid off) is therefore costing you 6% on an ongoing basis -- so you need to do better than that to gain an advantage and less well to suffer a loss.

If your investments return an average of 9% per annum over the life of the mortgage then you'd end up with an investment pot worth £156,395 -- enough to repay the mortgage and have £56,395 left over. On the other hand, if your investments do really, really badly and give a return of 0% per year over the 25 years, you'd be left with investments worth just £44,360 -- £55,640 short of paying off your mortgage. (In fact, according to the CSFB Equity-Gilt Study, the worst 25-year period for UK shares, taken as a whole, since 1869 was between 1896 and 1921 when shares returned 3.1% per year).

The big picture

This extra risk in interest-only mortgages is often made to sound very scary. "Do you really want to gamble with your house" is the sort of thing you might hear. But, looking at the big picture, the difference in risk between a repayment and an interest-only mortgage is less than many people suggest. Don't forget that both involve borrowing, say, £100,000 to buy a property of uncertain value!!

Broadly speaking, you'd expect property prices to increase in line with average earnings over the long term. Estimating that at 4.5% per year, then we'd expect our £100,000 house to treble in value over 25 years to £300,000. On this basis, a repayment mortgage would leave us with a net £300,000 after 25 years (made up of the house).

With the interest-only mortgage, even if your investments go completely up the spout and are worth precisely nothing after 25 years, then you'd still be left with a net £200,000 (the £300,000 house less the £100,000 mortgage). If the investments matched the worst 25-year period for UK shares since 1869 (producing a return of 3.1% pa) then you'd be left with a net £266,475. If our investments did okay and returned 9% per year (which is broadly consistent with the long-term average of 9.5% pa since 1869 less 0.5% for costs), then we'd end up with a net £356,395. I don't think I'm being totally too free and loose by describing that as a relatively small risk in the scheme of things.

Investment returns tend to follow interest rates...

In fact it isn't even as bad as that, since investment returns will tend to follow long-term interest rates. In that nasty 1896-1921 period when shares returned only 3.1%, interest rates averaged just 3.6%, so the interest-only mortgage wouldn't have left us that far behind.

The best 25-year period since 1869 was 1974-1999, which has the advantage of beginning at the end of the 1974 crash and ending with the top of the market in 1999. But the most relevant factor is that it coincided with the very high inflation and interest rates that we saw towards the end of the 20th century. Over the period, shares averaged 22.2% pa compared to interest rates that averaged 10.2%.

...we'll probably re-mortgage anyway...

The situation is also affected by the fact that most people will move house, or otherwise re-mortgage, several times over a 25-year period. Some might increase their mortgage along the way, some might reduce it and some might clear it all together, but one way or another, what you do here is likely to make far more difference to the size of your mortgage after 25 years than whether you go for the repayment or interest-only option.

...and in any case we should be saving for our retirement

In reality, on top of financing a mortgage, we should also be saving hard for our retirement. If we're aiming to pull together, let's say, £200,000 over the next 25 years to get us started with that and we expect an investment return of 6%, then we'd need to be saving £294 per month (which puts our monthly contribution to paying of the mortgage of £147 into some sort of perspective). Anyway, assuming we manage it (and also assuming of course that the property grows at our projected 4.5% per year), then the repayment mortgage would leave us with net assets of £500,000 after 25 years, while the interest-only option might leave us with between, say, £466,000 and £556,000 (a house worth £300,000 and investments worth between £166,000 and £256,000 once we'd paid off the mortgage).

Stick to the basics

Rather than getting worked up about the differences between interest-only and repayment mortgages, it's more important to stick to the basics. The first of these is that taking on a debt of £100,000 to buy a house is a risky business in itself, at least in the short-term, however you choose to pay it off. So you need to make absolutely sure you don't overstetch youself with the repayments. If you can't pay, then they'll take your house (and it will most likely be just at the worst possible moment).

The second 'basic' point is that we all have a stack-load of saving to do. One way of doing that saving is to pay off the mortgage, but we'll all need to do some hard saving via an ISA or a pension on top of that. If you choose to take an interest-only mortgage and focus extra hard on your other investments, then recognise that it involves a little risk, but it's not as much as most people will tell you. The biggest risk is that you get lazy and simply don't save enough. One important advantage of a repayment mortgage is that it does, at least, effectively force you to save a little.

More: The Fool's Mortgage Centre; The Fool's ISA Centre; How Much Should You Be Saving?