The Danger With Interest-Only Mortgages

If you want to cut your monthly costs, switching to interest-only mortgage payments may seem like a good idea. But doing so could cost you far more than you realise...

Your mortgage is probably your biggest monthly bill. So when finances become stretched it seems an obvious answer to cut back your mortgage costs as much as possible.

You may be tempted to ask your lender if you can temporarily switch to interest-only repayments while putting your capital repayments on hold. Sure, it will trim your mortgage outlay for a while. But the trouble is, tinkering with your repayments like this can cost you a lot more than you might think in the long-run.

Let's say you want to borrow £160,000 over 25 years. Think about these two options:

Option one

You take out a repayment mortgage (where the capital sum borrowed and interest are repaid simultaneously over the term) over 25 years at an interest rate of 6%. That means your monthly repayments are £1,030.88. All things being equal, you'll pay a grand total of £309,264 over the term.

That sounds like a heck of a lot. But now take a look at option two:

Option two

You take out an interest-only mortgage for the first five years at the same rate of 6%. This time your monthly repayments will be lower at £800. So you'll be making a handsome saving of £230.88 each month. That sounds rather good. But does this really make good Foolish sense?

Over the next five years you'll pay a total of £48,000 in monthly interest repayments, but you won't repay any of the capital you have borrowed, i.e. your £160,000 mortgage.

After five years, you decide you need to start chipping away at your debt so you switch to a repayment mortgage for the remaining 20 years of the term. Of course, your payments increase significantly for two reasons. One: to make up for the fact that you haven't repaid any of the capital in the previous five years. And two: because you'll be repaying the capital from now on.

Your new repayments for the next 20 years will be a lot higher at £1,146.29 (assuming the same 6% rate throughout). This is no joke if your financial situation hasn't improved considerably since you first took out your mortgage. You'll now be paying more than £4,000 extra every single year just to clear the debt to your lender.

Over the next 20 years you pay a total of £275,109.60. But don't forget the £48,000 you have already paid in interest-only payments over the first five years. That means your grand total is £323,109.60.

In other words, taking the interest-only route and switching to a repayment mortgage after five years will actually cost you an extra £13,845.60.

(For a summary of the figures see the table at the end of the article).

This is why repaying your mortgage on an interest-only basis should really be your last resort as -- in this example -- it could cost you almost £14,000 more for the privilege.

Of course, you may have taken out a repayment mortgage originally but decided, because of a heavy repayment burden, to switch to interest-only midway through the term. But that will have a similar effect as the example shown above and will ultimately cost you a great deal more overall.

To figure out exactly how your financial situation would be affected if you switched to an interest-only mortgage, you can use our nifty new remortgaging calculator.

So what's the solution?

Before you resort to the interest-only option, consider whether it is more cost-effective to remortgage to a more competitive deal. A broker at The Fool's mortgage service will be able to tell you whether a new deal is the best option for you. After all, with dramatic cuts to the base rate last week, you may be able to find a cheaper loan now.

That said, you may find moving to interest-only is your only option. Particularly if the alternative is falling into arrears with you mortgage. If you really have no choice, try to switch back to a repayment basis as soon as you can. That way you'll limit the amount you rack up in extra interest.

And remember you may be able to compensate for the interest-only period by overpaying your mortgage when your financial situation improves.

Interest-only versus repayment mortgages

	Interest-only	Repayment
Payments for first five years	£800	£1,030.88
Payments for remaining 20 years	£1,146.29	£1,030.88
Total paid over first five years	£48,000	£61,852.80
Total paid over remaining 20 years	£275,109.60	£247,411.20
Total amount paid over 25 years	£323,109.60	£309,264
Extra paid by choosing interest-only option	£13,845.60

More: The Right Mortgage: Discounts Vs Trackers |How Will The Rate Cut Affect Your Mortgage? | Find a great mortgage via The Fool's award-winning mortgage service