Cutting your monthly payments by taking out an interest-only mortgage is tempting if you're struggling to buy a home, but could prove one of the costliest mistakes you'll ever make.
Buying your very first home has never been easy so I can understand why you might be tempted to go with the seemingly cheapest possible option and deal with the consequences later. Interest-only mortgages fit nicely into this category, but they can be a risky choice.
But before I explain why, let's have a quick look at the difference between interest-only and repayment mortgages first:
Interest-Only
Interest-only mortgages do exactly what they say. Your monthly mortgage payment goes towards repaying the interest on your loan only -- it doesn't repay any of the capital debt you owe your lender. You will still owe the original sum you borrowed at the end of your mortgage term (although bear in mind inflation is likely to have eroded the value of this sum, to some extent).
This type of mortgage should run alongside an investment vehicle, such as an ISA (Individual Savings Account) which, fingers crossed, grows sufficiently in value to repay the capital at the end of the mortgage term. But without any guarantee of how well it might perform you run the risk of a potential shortfall.
All things being equal, interest-only mortgages will cost you more in the long run than repayment mortgages. This is because you are not reducing the capital debt you owe the lender every month, so will have to pay more interest throughout your mortgage term.
Repayment
With a repayment mortgage you chip away at the capital debt every month. And because your debt is smaller every month, you pay less interest -- so, in the end, your total interest bill is lower than an interest-only mortgage.
Don't be fooled by the fact that the monthly payments on a repayment mortgages are more expensive than an interest-only mortgage. At the end of the day, because you pay far less interest on your debt throughout the mortgage term, a repayment mortgage should work out much cheaper.
What's more, a repayment mortgage is the most secure option because, unlike a combined interest-only mortgage and investment vehicle, the mortgage is guaranteed to be repaid in full at the end of the term (as long as you don't fall into arrears).
The popular choice
But even though repayment mortgages are a safer choice, they are becoming less popular. According to Paragon Mortgages, market share has declined from 70% in 2003 to 58% this year while the number of borrowers taking out interest-only mortgages has grown. Indeed, figures from the Council of Mortgage Lenders (CML) also show interest-only applications rose by 33% to 222,400 in 2006.
And it's easy to see why. In the example shown below you could cut your mortgage payments by over £2,700 in just twelve months by going down the interest-only route.
Mortgage Type | Monthly Repayments: £150K @ 5.69% over 25 years |
|---|
Interest-Only
|
£711.25
|
Repayment
|
£938.23
|
Difference Over 1 Year | £2,723.76 |
But let's take a look at the total cost of this mortgage over the full mortgage term:
Mortgage Type
|
Total cost of £150K mortgage @ 5.69% over 25 years
|
|---|
Interest-Only
|
£363,375
|
Repayment
|
£281,469
|
Difference over 25 years | £81,906 |
As this table shows, an interest-only mortgage appears to cost £2,723.76 less each year - but, because you still owe your original debt of £150,000 at the end of the mortgage term, it actually costs £81,906 more than a repayment mortgage.
However, in my view, there's nothing intrinsically wrong with interest-only mortgages as long as you make payments to a robust investment plan alongside your monthly mortgage payments. That way the mortgage loan should be comfortably settled up at the end of the term - but will mean that your monthly outlay may be similar in size to the monthly outlay of a repayment mortgage.
I should point out here that a particularly well-performing investment plan, which usually invests in shares, could produce a surplus above and beyond your mortgage debt. But bear in mind that, in the example above, it would have to produce a £81,906 surplus just to break even with the repayment mortgage. Many people who took out endowment mortgages in the 1970s and 1980s suffered great losses because their investment vehicles did not perform as well as expected.
Also, interest-only mortgages take more effort than repayment mortgages. You'll need to keep track of your investment vehicle to make sure it's on target to repay your capital debt. And if you need to borrow more then you'll need to step up your savings into your investment plan accordingly.
What greatly concerns me about interest-only mortgages is that research from the Financial Services Authority (FSA), which regulates mortgage lenders, suggests one in ten people who take out interest-only mortgages have little or no idea how they will repay the debt and have no repayment plan in place.
Make Interest-Only Work For You
I appreciate that, for many first-time buyers, this is the only way to put home-owning within reach. And if affordability is an issue, then the good news is that it's possible to make interest-only mortgages work for you over the short-term.
This is because, if you opt for an interest-only mortgage instead of a repayment mortgage, the smaller monthly payments should be easier on the pocket. You could stick with that approach for say, two years and then switch to a repayment mortgage later on once your finances are in better shape.
Although this will allow you to get on the property ladder sooner, if you want to keep to the original mortgage term expect a significant increase in your monthly outlay after those first two years are up. Your repayments will be greater for two reasons: first, the cost of repaying capital as well as interest has been factored in. Second, you'll need to catch up on capital repayments missed during those first two years.
For this approach to work you'll need to be pretty confident your finances will improve or the new repayment mortgage won't be within your means. And don't, whatever you do, forget to make the switch. This is more easily done than you might think especially if you have got used to budgeting around your lower repayments.
With runaway house price growth over the last few years, you may be tempted to rely on future rises to provide enough equity in your property to repay the capital back to your lender. But this could be very risky if house prices don't increase as anticipated. You could then be faced with a serious shortfall which may force you into selling the property to repay your debt.
And what are you going to do then? Buy another home which will no doubt need a whole new mortgage? Hardly the most effective strategy, is it? Interest-only mortgages certainly have their place but remember when you buy a home you always take on a commitment to repay the interest and the capital and there's just no getting around that. Burying your head in the sand when in comes to your mortgage is foolish, not Foolish, and will only cost you more in the long-term. So don't do it!
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