How to profit from an interest only mortgage

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!