The risk of interest only mortgages

Interest-only mortgages are a relatively new beast in the mortgage market. They sound good news. Payments seem to be low, therefore you can borrow more. But what about that capital repayment? Is this a dangerous path to take?

An interest-only mortgage enables you to only pay off the interest on the mortgage loan as you go. But, as with any mortgage, you will have to pay back the original loan (or capital – the amount you borrowed) at the end of the period.

In a traditional repayment mortgage, each month you are paying mortgage interest and part of the capital debt. It is calculated so that the payments are evenly spread across the term. Thus, on a 25-year mortgage, after 25 years you have paid off the debt completely – nothing remains to pay.

In an interest-only mortgage, your monthly repayments consist only of the interest on the loan. On a mortgage of £100,000 that would mean a saving of £2,000 every year.

That’s the good news. The bad news is that at the end of the loan period, the capital debt is still outstanding. In the example above, at the end of the term you would still owe the lender the £100,000. Now that is bad news.

Your monthly repayments were nicely reduced, and over twenty-five years on a £100,000 mortgage you would save around £50,000 on repayments. But you’ve got to pay back £100,000. Anyone who took out a repayment mortgage at the same time, and kept up their repayments would now be debt-free – though £50,000 worse off.

But now if you’ve got to pay back £100,000 – you will be £50,000 worse off.

In figures:
On a repayment mortgage of £100,000 over 25 years the monthly repayments are £614.09 and the total payment is £184,227.
On an interest-only mortgage of £100,000 over 25 years the monthly repayments are £458.33 and the total payment is £237,499 (including paying back the £100,000).

So you’ve borrowed the same amount over the same length of time, but the interest-only repayments and debt clearance end up costing you £50,000 more. The reason for that is that as you have not paid back any of the £100,000 capital debt, the lender continues to charge interest on the whole loan for the whole period.

Conversely, with a repayment mortgage you are paying back your debt from you very first payment, and over the course of twenty-five years it becomes less and less until it’s all gone. Every month, the amount you owe the lender is getting less, and therefore so does the interest.

So now an interest-only mortgage might seem like a bad idea.

But it can be suitable in the right circumstances.

For example, if you’re financially stretched, or desperate to get on the property ladder, or take another step up it – and you’re sure your income will soon be going up, then an interest-only mortgage could be the right thing. Be sure to understand the extra costs involved.

And as soon as you can afford the higher monthly repayments of a repayment mortgage, it would good to switch to it. Some products, such as HSBC’s Homestart mortgage all you to switch from interest-only to repayment mortgage automatically after three years – crucially, at no extra cost usually associated with remortgaging.

What you should not do is depend on an increase in the value of your property to enable you to pay off the capital debt at the end of the period of the mortgage. Apart from the fact that the property market cannot be relied on to deliver you the required increase (no matter what the previous record of the market is – imagine a crash just at the wrong time), adopting this strategy would mean that you would have to move house at the moment your mortgage is paid off just to pay for the house you’re leaving. In addition, all other property prices will have gone up by the same percentage as yours, so you may end up needing another mortgage - twenty-five years after your first one.

How else could an interest-only mortgage be useful? Well, you could adopt the endowment mortgage principle yourself. That is, you could invest the difference between interest-only monthly repayments and repayment mortgage monthly repayments – that’s £156 a month. Over 25 years this comes to £46,800 without interest. An interest rate of 5.8% over the whole period would suffice. But a) can you achieve that interest rate without risk, and b) have you the discipline (or indeed the money) to fund such a savings plan?

Choosing an interest-only mortgage can leave you open to risk and future pain. If you do have an interest-only mortgage and no provision for the capital debt at the end, then you need to take action now. Start saving what you need to cover the debt or, even better, switch to a repayment mortgage as soon as you can afford it.