Interest Only or Repayment?
I thought Iâ€™d continue the mortgage theme started by Dolphin. A lot of this will be old hat to most of our readers, but it may be of interest to some.
At the moment anyone thinking of buying a house may still find that they need a large mortgage. So they want to get one that keeps their monthly payments as low as possible. There are several ways of doing this, but some are riskier than others.
With all the mortgage products on the market there are actually only two types of mortgage. The repayment mortgage and the interest only mortgage. All the trackers / fixed / flexible are just ways of structuring the payments.
Letâ€™s start with the repayment mortgage.
With the repayment mortgage the borrower will pay the interest accrued each month and a small part of the capital borrowed. That means that as long as you keep up the payments and pay on time you are guaranteed to repay the loan amount in the agreed time. The standard length of a repayment mortgage is 25 years. But by increasing the term to say 30 or even 35 years the monthly payments will come down. Going out to 40 years however will bring little further benefit. But by extending the term of the loan you will pay more in interest overall. If you overpay a repayment mortgage you will bring forward the date that you fully repay the loan. A very rough guide being that by overpaying by 5% per month you could knock 5 years off of a 25 year mortgage and turn it into a 20 year term. Generally a repayment mortgage is considered right for cautious people.
Now for the interest only mortgage.
Here you only pay off the accrued interest every month. The amount of capital outstanding remains the same. So, if you borrow Â£100,000 and make your monthly payments on time you will still owe the bank Â£100,000 when the mortgage ends! Sounds a mad thing to do, but many start out this way when buying their first house promising themselves that they will convert to repayment as soon as they can afford it. Many times they just keep extending the term as â€˜that right timeâ€™ never seems to arrive. Others think that inflation will erode the loan to an insignificant amount.
Up until recently many lenders allowed people to take interest only with no strings attached. This is called â€˜Pure Interest Onlyâ€˜, usually associated with BTL. Now though the majority of lenders insist on there being a stated â€˜repayment vehicleâ€™ in place to pay off the loan at the end.
Repayment vehicles can take the following sort of forms:
Sale of residence - if the LTV of the loan is low and the house large then it is reasonable to say that when you get older you will downsize and pay off the mortgage in the process. Not considered reasonable for high LTV cases.
Sale of second residence - obviously fine as long as the figures stack up.
Endowment - Traditionally the vehicle of choice in years gone by. The idea being that the combined cost of the interest only payments and the endowment premiums are less than an equivalent repayment deal, and you get life insurance thrown in. The trouble is many have not performed. Mis-selling occurred if the provider promised it would meet or exceed the amount needed, when no guarantees can be given. Why mis-sell? Because you get the mortgage procuration fee as well as commission for the endowment sale, happy times for mortgage sellers.
ISA - This is run along the same lines as the endowment option with the same sorts of risks. But may not have life cover attached. There is also the temptation to spend the money as it is not tied up in the same way as an endowment.
Pension - With a pension you have the option of drawing down 25% of the value of your pension in a lump sum after the age of 50 (55 from next year!) So, as long as your pot is predicted to reach four times the size of your mortgage at the right time then you can declare this as the vehicle. Once again, a bit risky as your pot might not grow at the expected pace.
The interest only mortgage is therefore suitable for those who donâ€™t mind taking a bit of a risk, it is considered the â€˜adventurousâ€™ option.
By overpaying this type of loan you will reduce the capital outstanding at the end.
So, interest only in one guise or another can keep your monthly payments down, but it comes with the attached risk that you may not be able to pay the loan off at the end.
One thing you can do is combine the two and have part of the loan on interest only and part on repayment. A sort of mix and match to suit your requirements. You may have an underperforming endowment you're keeping for example.
Most lenders will let you transfer from interest only to repayment, or you can just overpay to achieve it (check for Early repayment Charges with your lender first!). Lenders are very wary of letting you transfer the other way though. They think you are in financial trouble, some wonâ€™t even consider it for any reason.
At the end of the day the choice is yours, but I wonder if there are not a lot of people out there who wished they had opted for the safer option of a repayment mortgage all those years ago?