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Interest-only mortgages

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What are the pros and cons of taking out an interest-only mortgage, and what type of borrower are they suitable for? (Updated 07/10/11)

When you take out a mortgage, whether you’re a first-time buyer or remortgaging, you’ll have to decide how you’re going to pay your mortgage back. You can either opt for a repayment mortgage or an interest-only mortgage.

If you have a repayment mortgage, your monthly repayments go towards paying off both the capital you borrowed and the interest payable on it. But on an interest-only mortgage your repayments will only pay the interest charged on the amount you’ve borrowed.

On an interest-only mortgage, your monthly payments will be lower but, when you come to the end of your mortgage term, you will still owe the amount you originally borrowed.

Four in 10 households have interest-only mortgages, according to the Financial Services Authority (FSA). This guide looks at the pros and cons of this type of mortgage in the current economic environment.

What is the difference between a repayment mortgage and an interest-only mortgage?

Repayment mortgages	Interest-only mortgages
Make monthly repayments for an agreed period of time (the term) until you’ve paid back the loan and interest. This is considered the least risky mortgage type, as well as the easiest to understand.	Make monthly repayments for an agreed period, but this will only cover the interest on your loan. You’ll have to pay into another savings or investment plan each month as well.

You must remember that with an interest-only mortgage, at the end of your mortgage term (typically 25 years, however this could be longer or shorter) you will still owe the original amount you borrowed, the capital.

The idea behind this type of mortgage deal is that you have a separate savings or repayment vehicle running alongside it, into which you also make monthly payments, so you have the money to pay off the capital at the end of the term. Alternatively you could know that when it comes to the end of the term you’ll have other money to use to pay off the capital – like an inheritance for example.

Interest-only example:

Let’s take the example of a £150,000 mortgage at 4% over 25 years. According to John Charcol’s mortgage calculator the loan would cost you £791.76 a month on a repayment basis or £500 on an interest-only basis, £291.76 less.

However, you must remember that at the end of the mortgage term, the interest-only loan will have only paid off the interest - leaving the original £150,000 debt to be repaid, whereas the higher monthly payments of a repayment mortgage would have cleared the debt.

What is a repayment vehicle?

Most customers with an interest-only mortgage will make monthly contributions to a repayment vehicle, such as an ISA, to pay off the capital borrowed on their house.

Contributions to the repayment vehicle are invested with the aim of building a lump sum that will be enough to pay off your mortgage at the end of the term

To avoid financial trouble, you should monitor your repayment vehicle, as the performance of a repayment vehicle is not guaranteed, and you will need to keep a watchful eye on it to ensure you are not left with a shortfall.

If you can manage your finances properly, an interest-only mortgage can have a one advantage - you can choose your own repayment vehicle, one that is tax-efficient and which will show good growth.

This is only an advantage if you can manage your finances properly, and anyone considering an interest-only mortgage should always seek guidance from an independent financial adviser before going ahead.

Who is suitable for an interest-only mortgage?

Some people opt for interest-only mortgages when they expect their financial situation to change later on, at which point they plan to switch to repayment mortgages. These groups of people typically include:

First-time buyers who are faced with the cost of furnishing their first home
Professionals who expect their salary to rise within a couple of years
People with short-term financial problems due to redundancy or illness.

When house prices were rising financial advisers often recommended interest-only mortgages as a way for people to get on the housing ladder. The thinking was that they could switch to a repayment mortgage or remortgage in a couple of years time when the value of the property would have risen to the point they’d have a better choice of mortgage deals.

However the current climate of falling, or stagnant, house prices mean that this is no longer the case. Someone who pays only the interest on their mortgage for a couple of years might find that when they come to remortgage their property is worth less than the outstanding mortgage amount – and so they’re in negative equity. This makes remortgaging impossible as no lenders will lend more than the property is worth.

For this reason most experts warn against taking out an interest-only mortgage at the moment unless the borrower has a repayment vehicle in place.

Sarah Robson of the Council of Mortgage Lenders says: “If you’re considering taking out an interest-only mortgage you need to realise you won’t be repaying any of the capital and, at the moment, you can’t rely on house price inflation to provide you with an equity cushion.”

How do lenders view interest-only mortgages in the current economic climate?

Since the onset of the credit crunch, most UK lenders have tightened their criteria, including their willingness to lend interest-only mortgages.

With falling house prices, unless the borrower has a healthy deposit, and often a specific repayment vehicle, lenders are reluctant to lend interest-only mortgages.

Lenders are also less likely to accept some of the previously acceptable methods of repaying the loan, such as overpayments or sale of property.

What are the dangers of an interest-only mortgage?

There are a number of risks with interest-only mortgages, all of which should be considered when choosing how you want to repay the money you borrow.

Firstly, house prices are never guaranteed - while overall trends suggest they will increase, recent figures from the Halifax house price index have shown a 2.6% decrease in property prices over the last 12 months.

Those taking out interest-only deals without a repayment vehicle to pay off the capital are speculating that property prices won’t fall because, if they do, their debt will be bigger than the value of their home. This is known as negative equity.

Secondly, many people sort out their mortgage and then forget about it. If you don’t convert your interest-only mortgage to a repayment mortgage as soon as is financially practicable, and you have not been paying into a repayment vehicle, there is a very real risk you may get to the end of your mortgage term still owing all of the capital you initially borrowed.

With an interest-only mortgage, there is no guarantee you will have sufficient funds to pay off the mortgage at the end of the repayment period. You must monitor the performance of your repayment vehicle to check that at all times it is on track to cover the capital sum required in the future.

And finally...

Taking out a mortgage on an interest-only basis is a risky strategy and should only be considered if you have a repayment vehicle or strategy in place that you’re sure will pay off the capital at the end of the term.

In some cases it might be acceptable to be on interest-only for the short-term (for example, for a year or two), and switching to a repayment mortgage as soon as possible.

If you are considering an interest-only mortgage, we would strongly advise you contact an independent financial adviser (IFA) or whole-of-market mortgage broker, who can offer you advice tailored to your specific circumstances.

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