The risks and rewards of interest only mortgages

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Interest only mortgages are becoming more popular as borrowers seek to reduce their monthly mortgage payments as interest rates are rising. There are risks with interest only mortgages, however, as we discuss in this article.

Conventional repayment mortgages are structured so that some of the mortgage capital is paid off each month by the monthly repayment. The rest of the monthly payments pay the interest due on the loan.

As the mortgage term progresses, the capital repayment element is gradually increased so that by the end of the mortgage term, the loan is paid off entirely.

Interest only mortgages

Interest only mortgages differ from repayment products because the monthly repayments only cover the interest charges. The loan is not gradually paid off so at the end of the term you owe as much as you did at the beginning.

Only paying the interest rather than reducing the amount borrowed seems beneficial because the monthly repayments are lower, which is attractive as interest rates rise.

The problem is that you still have your original debt at the end of the term so you either have to have an investment strategy to repay the debt or sell your house to return the loan amount to the lender.

Robust payment plans required

If the requirement to sell your house at the end of your interest only mortgage term is to be avoided, it is vital that a robust payment plan is set up so that the loan amount can be repaid to the lender.

As 24pc of all new mortgages are interest only mortgages, there are many people who will be in a position to repay their mortgage at the end of the term.

Research by the FSA, however, has shown, that a significant number of people with interest only mortgages had no idea how they would pay back the capital they had borrowed.

Although there appeared to be a good understanding of the risks of interest only mortgages, it still seems that many people still need to tackle the thorny problem of repaying the original loan.

Lets now look at some of the strategies that can be used to reduce the risk to interest only borrowers.

Hope that property prices will increase

Hoping that property prices will continue to rise so that you are provided with a nice lump sum of equity at the end of the mortgage term, is probably what most people do.

Although history shows that over time property prices have increased beyond the rate of inflation, there is no guarantee that they will continue to do so.

Recent plans by the Government to substantially increase house building may reduce house price growth in the future, possibly just keeping in line with inflation.

The main problem, though, is that you have to sell the property at the end of the mortgage term. Whereas this may be fine for a buy to let investor, you may not be so happy to be forced to sell your home.

Savings accounts

Whilst making regular savings into an account with a long notice period, which therefore earns maximum interest, may seem sensible, there are pitfalls.

Mortgage rates are generally higher than savings rates so your savings account will never catch up with your mortgage. Also interest from savings accounts are taxed so your interest earned will be less than you think.

Making regular savings is always a good idea and a long term savings plan would certainly help pay off a chunk of your loan amount at the end of the term, and may even save you from having to sell your house, depending on your general financial circumstances.

Insurance policies

A financial advisor would be able to help you choose a suitable insurance plan which reinvests investment profits back into the plan, growing your capital in the fund over the years.

These are fairly complex devices and you should certainly seek financial advise, however be wary as this is was how endowment policies were designed and they have experienced significant problems recently.

Stocks and shares

Historical performance of the stock market has again outstripped inflation and spectacular gains can be made by choosing the right share.

However spectacular losses can also be made so this form of investment is only for those who are prepared to take risks, know what they are doing and almost certainly are seeking professional broking and fund management advise.

Reducing the risks by investing in unit trusts may be a sensible approach and over time could repay back your mortgage capital, but qualified financial advise must be sought before embarking on this strategy.

Over paying your mortgage

It may seem odd that paying more each month for your mortgage than you need to is a sensible strategy. You're trying to reduce the monthly mortgage payments by having an interest only mortgage in the first place!

Well actually this is a highly sensible and risk free approach as every overpayment reduces the loan amount. This return reduces the interest that you owe which in turn can reduce your monthly payments.

Although this sounds a bit like a repayment mortgage, there is one major difference and that is that you don't have to make over payments each month. You can choose to overpay as and when it suits you.

Should you get a bonus or unexpected windfall then go to your bank and pay it off against your mortgage rather than put it in a saving account.

This is beneficial for the following reasons:

  • Mortgage interest rates are generally higher than saving account rates
  • Interest on savings accounts is taxable so is reduced if you are a tax payer
  • You are reducing your debt and therefore reducing the interest owed on that debt
  • You have just bought a tiny bit more of your house from the bank!

A word of caution

Read the terms of your mortgage carefully to ensure that your overpayment doesn't breach their rules and trigger an overpayment penalty.

The Nationwide, for example, allows a £500 over payment per month without incurring any penalties. So if you want to pay off £1000, pay off £500 now, put the other money into a savings account and pay it off against your mortgage next month.

Nothing wrong with interest only mortgages

Interest only mortgages are certainly a valid option for many borrowers, particularly those who have a repayment strategy in place, or are fully prepared to sell their property to meet the loan repaymentat the end of the mortgage term.

If you are attracted to an interest only mortgage, then we hope that this article has made you think of the implications and risks involved as well as given you a few ideas about how to pay off the loan.

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