The humble interest only mortgage has become a byword for financial recklessness. In the eyes of many, such mortgages are the UK equivalent of sub-prime loans in the US.
But I disagree:
- Sub-prime mortgages saw US banks scanning the worst localities for the worst customers. Just to make sure things ended badly, the resultant loans were sliced and diced into mortgage-backed securities and sold with an often fanciful credit rating. Cue the credit crisis.
- An interest only mortgage is simply a financial product with the potential to be misused.
Comparing a sub-prime mortgage to an interest only mortgage is like comparing crack cocaine with aspirin. Both can kill you, but with an aspirin – or an interest only mortgage – you’ll be fine provided you read the label and follow the instructions.
I don’t have a mortgage, but if and when I buy a home I’ll probably go interest only. In this article I’ll explain why.
First, let’s recap what an interest only mortgage gives you, and why it’s different.
A repayment mortgage versus an interest only mortgage
When you buy a house, you usually borrow a huge amount of money from a bank. Naturally, the bank wants it back someday. Until then, it charges interest.
Ignoring any initial deposit, the amount to be repaid therefore consists of two components:
- Total repaid = Initial sum borrowed + Interest over the lifetime of the loan
A bank could just ask for the total to be paid after 25 years. But because – despite all recent evidence – banks aren’t completely nuts when it comes to mortgages, they almost invariably ask for interest payments from the month you take out the loan.
Repayment mortgage
With a repayment mortgage, you pay interest every month. You also pay off a small portion of the capital sum you borrowed. Both amounts are worked out so that at the end of 25 years, you’ve repaid the bank in full and the house is yours.
Alternatively, the bank will sometimes let you put off repaying the initial sum you borrowed until the end of the loan term. (The bank has your house for security, so it can feel pretty confident about getting its money back).
This postponed payment option leads to the second type of mortgage.
Interest only mortgage
Your bank allows you to pay only the interest due every month, and leaves you to find a way to repay the capital sum at the end of the term. Generally you’d do this via alternative savings, but some people plan to inherit money or to sell other assets before the 25 years are up.
Why an interest only mortgage can be dangerous
Critics of interest only mortgages say that’s all very well in theory, but there are big problems in practice:
- Many people can’t save for toffee, so they need the forced discipline of a repayment mortgage in order to buy their home.
- People may buy houses they can’t afford with an interest only mortgage. They work out they can make the interest payments, and hope that something turns up in the next 25 years to pay for the house.
- Some people actually plan to sell their house at the end of the term, repay the bank, and keep any difference that’s accrued over the 25 years. This may make sense individually, but on a wider scale it turns property buying into mass speculation on house prices.
For more sensible investors, the risk of an interest only mortgage is clear. If you don’t have the money to repay the bank for your home, you’ll have to sell it to cover the cost. And if your house is worth less than you paid for it, you’ll owe the bank the difference.
Wealth warning: I wouldn’t argue with anyone taking out a repayment mortgage. The simplicity and peace of mind it gives should not be dismissed. Your house is at risk if you don’t repay your bank!
Monevator is a blog about taking control of your own finances, however. And if you’re responsible with your money and committed to making it go further, then an interest only mortgage gives you more options.
The two key benefits of an interest only mortgage
With an interest only mortgage, it’s up to you to save and invest your money to repay the capital you owe.
In return for taking on this responsibility, you get two big benefits:
- Flexibility – You can usually pay off more of the capital owed when you have more money, and less when you don’t. This makes an interest only mortgage ideal for freelancers and the self-employed, but also for anyone who wants tighter control of their financial commitments.
- Ability to profit – It’s risky, but you can try to beat the returns you’d get from repaying your mortgage by investing in shares. Looking at historical UK asset class returns, over a 25-year period you’ve got a reasonable chance of coming out ahead by investing in equities to build up a lump sum, compared to if you’d just used a repayment mortgage – especially with today’s low mortgage rates.
Personally, I’d only try to profit by using an interest only mortgage if I was sure I could save much more than required to repay the capital sum. (If you end up with twice the cash you need, you’re not going to complain!)
Also, you’ll need to treat your repayment date like a retirement date, and so (hopefully) take profits by tweaking your asset allocation as the due date nears. This way you’re not too exposed to a bear market in shares.
Be under no illusions, you’re effectively borrowing to invest if you try this. That isn’t usually a good idea, but the relatively cheap rate of mortgage finance makes it feasible. Tax efficiency is vital, which will usually mean using an ISA in the UK.
Incidentally, property investors nearly always go interest only. In their case, it’s because interest payments can be deducted from profits to reduce their tax bill, but capital repayments cannot.
Further reading:
- Jim Slater, the renowned and wrinkly UK investor, wrote a book
about paying off an interest only mortgage by investing in an ISA. I’ve only skimmed it, but I liked his other books. Beware: It will likely include over-optimistic annual return rates!
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Hi Monevator. I bought my first house in the early nineties with an interest only tracker mortgage. My thinking was my investments would beat the mortgage and the mortgage providers probably charge a premium for a fix. In a sense this is the most uncertain kind of mortgage, but in theory it ought to work out cheapest in the long run. In 2000 I switched to exactly the opposite kind of mortgage, a repayment mortgage capped for the full 25 year term.
I am so glad I did. Coincidentally, at the top of the cap, my mortgage costs a few pennies short of £1,000 a month to repay. I now have the security of knowing that I should never have to pay more than that and after 25 years I will definitely owe nothing. I understand your reasoning, but my mortgage is such a big debt I want to do everything I can to make sure it remains affordable.
Long periods of sub-par stockmarket performance are very rare, but I don’t want to be caught out by one. Likewise, we haven’t had high interest rates in the last two decades, but we did before then. Since a mortgage is a multi-decade liability, I took the view it was best to prepare for multi-decade contingencies.
Having my debt pinned down this way means I can run my investments, and my career, without being too worried about it. I don’t have to take undue risks, or work at a job I hate, because I need the money.
Obviously your blog is about taking control of your finances and no doubt you could remain in control with an interest only mortgage. The same answer isn’t right for different people. But I thought you’d be interested in my experience!
I used my interest only mortgage in exactly the way you describe – it was a flexible capped one with Birmingham Midshires. I was lucky though – I pushed my spare towards investments and sold up in early 2007. I’d like to say I was bright and anticipated the crash but it was more I wanted the peace of mind on finally canning the mortgage early, as I had done well enough investment wise to shorten my term.
Another advantage of a flexible mortgage is that on occasions where you can’t work out what to do with the stock market you can put the cash to the mortgage and reduce the interest to really low levels. It was satifying to pay it all down bar £1000 and pay less than £5 a month for a while and yet know I could call on nearly 100k if I wanted to. As you highlight, however, the key is to only use the debt money on strategic investments. New kitchens, foreign holidays and cars don’t count 🙂
.-= ermine on: the pros and cons of cycling to work =-.
@Richard – Yes, definitely appreciate your extensive comments. I hope I was clear in the piece that there are risks, and that I certainly haven’t got a problem with someone choosing repayment at all. Thanks for stopping by!
@ermine – Interesting comments, and regarding over-payments, I agree. I have a piece on offset mortgages hewn from this article that I’ll post at some point on exactly that strategy.
beware the offset mortgage. Under some circumstances (eg credit crunch) the small print states a bank is entitled to forcibly reduce their exposure to your mortgage risk using your other funds. This happened to someone running a small business I know, as a result it screwed their capital investment plans. There are hazards of holding your debts and assets with the same institution. It isn’t just mortgages, credit cards are also worth holding with a different institution that your bank, though I imagine you will be unlikely to experience the conditions where that is hazardous 😉
.-= ermine on: the pros and cons of cycling to work =-.
Interesting article! I’ve always heard of this type of loan, but I didn’t know the full details.
I’m now worried for a friend that bought a house using an interest only loan. She told me that they can barely afford the payments, and to make matters worse, they were both layed off from work at the same time for about 5 months (both are employed again).
My friend, who has horrible credit, is probably both a sub-prime and interest loan both rolled up in one. Her family is definitely not the norm…
I’ll have to look into the business use of such a loan. I’ve been thinking about buying real estate and that might be the way to go!
.-= Money Reasons on: MoneyReasons Weekly Cache 2010, April 18 =-.
Another solution is to take out a 30-year loan but pay it off in 15 years by putting aside extra every month (in addition to your mortgage).
http://www.scienceandmoney.com/2010/01/22/the-true-cost-of-a-30-year-mortgage/
Here in the USA, I had a 15-yr fixed rate mortgage at 4.85% and was ending my fifth year last summer. I kept running through the numbers to see if refinancing at the new record low rates, even interest-only, would be worthwhile, but the answer was always, “no”. Interest-only rates had a premium tied in that never made it worthwhile to switch mortgages.
I did eventually find an adjustable rate mortgage (ARM) where a refinance would pay off. Rather than the common 1 or 3 or 5 year ARM, where the interest is fixed for a period (1 or 3 or 5 years) and then becomes adjustable, I found a 10 year ARM at 3.85%. Comparing the two loans (former and new), it seems that the home could be paid off in 5 years now rather than 7 years if I desire.
Are there ARM products in the UK that have long fixed periods?
Another way to use an interest-only loan is as a safety net. Get an interest-only loan, but pay principal and interest every month anyway. If you suffer job loss, you can scale back to interest only and probably avoid defaulting. With a conventional loan, the typical borrower is already close to the financial edge. If he suffers job loss, he will end up in a default situation right away because he is obligated to pay the full payment every month regardless.