Interest Only Mortgages

Interest-only mortgages – These mortgages cost less than repayment mortgages because, as the name suggests, there is no repayment of the capital during the mortgage term.

Mortgages involve paying back the capital debt – the sum you borrow – plus interest on that debt (the lender’s profit). The conventional repayment mortgage involves spreading this capital debt plus interest as monthly payments over the course of the term – often a couple of decades and more. Keep up the payments and, in due course, the mortgage will be paid off – guaranteed.

For an interest-only mortgage, you only pay the interest, so you cut your annual payments by upwards of £2,500 on a £100,000 mortgage at 5.5% for 20 years. The original capital debt remains outstanding from day one to day 7,305 when it becomes due to the lender as a lump sum. Should you not pay back any of the £100,000 capital debt, the lender will charge you (compound) interest on the entire loan for the entire term. Contrast this with a repayment mortgage, in which you chip away at the capital from day one, even though at first your payments are almost entirely pure interest.

Relying on an increase in the price of the property to pay off the capital debt at the end of the mortgage term is more than a high-risk strategy, it is foolhardy and, moreover, you would have sell your home and move out in order to get your hands on the cash to pay the lender.

However, interest-only mortgages are increasingly popular: research from the Financial Services Association shows that almost a quarter of all home loans are now taken out on an interest-only basis. But the FSA's research also reveals that around 15% of borrowers have either no idea or no credible strategy in place for how they intend to repay the capital owed.

Protect and survive?
Usually, people will pay an additional sum each month into some form of investment product that is designed to achieve the required amount by the end date. This brings an element of risk - that the investment product might not grow enough to pay off the loan (as many endowment policy holders discovered to their cost) – that many find too great for comfort.

Opinions vary on which available products are most appropriate, but all involve some risk. Endowment policies – stock market-based investment plans – are now rightly seen as far too risky; it is also possible to use cash from a pension plan to clear the debt but you have to keep up the payments, whatever other financial commitments you have.

An ISA (Individual Savings Account) is a healthier option: this tax-free investment, but you have to be a well-disciplined saver, save a reasonable sum each month and the stock market has to look favourably on whichever investments are chosen for you.

Interest-only mortgages – pros and cons:

 

PROS:

-         The monthly cost is considerably lower than for a comparable repayment mortgage.

-         Worth considering if you are stretched financially but wish to get on the property ladder.

-         Useful vehicles for Buy to Let arrangements (where the property is not the main residence of the mortgagee). –

CONS:

-         You will always own what you have borrowed.

-        The capital will be reclaimed as a lump sum on the due date.

-        You need a protection vehicle to pay of the lump sum in due course, but this itself involves an element of investment risk.