The Pros And Cons Of Interest-Only Mortgage Rates

Should you gamble with the roof over your head?

Choosing a mortgage naturally involves a lot of decision making and one of your first is whether you want to repay your homeloan on a capital and interest or an interest-only basis. Both methods have their benefits, and their drawbacks.

They also swing in and out of favour with borrowers. In 1988 87% of first-time buyers took out mortgages on an interest-only basis. By 2003, when endowment shortfalls became a huge problem for many borrowers, 87% of FTBs chose a capital and interest mortgage (i.e. a ‘repayment mortgage’).

But the tide turned again as a result of rapidly rising house price inflation. By 2007, 28% of first-time buyers were taking out interest-only deal – and the majority of them put no specified investment vehicle in place alongside their deal.

How do they work?

Interest-only mortgages are pretty straightforward. You borrow a certain amount to buy a house, say £150,000. Each month you pay the lender the interest on that borrowing and repay none of the outstanding capital debt. At the end of the term (usually 25 years) you owe the lender £150,000.

Of course you still need to repay the capital sum. Many borrowers take out an additional investment vehicle at the start of the mortgage and, as well as making their interest payments to the lender, they put additional money into this investment vehicle, such as an endowment, ISA or personal pension. The idea is that the investment will grow by enough over the mortgage term to repay the debt at the end. This is by no means guaranteed – you could be left with a shortfall…. or a surplus.

Five pros on interest-only

1. The monthly repayments to your lender are less than with a capital and interest mortgage. For example, our mortgage calculator shows that a £200k 25-year mortgage at 5% interest will cost you £1,169 a month on a repayment basis and £833 interest-only. For those trying to get on the ladder this could make the difference between being able to afford a property or not. Of course, if you also pay into an investment vehicle the total monthly payment will end up being similar to a capital and interest deal.

2. You do not have to stay on an interest-only mortgage. Many borrowers have used interest only as a way to get onto the housing ladder, and remortgages to a capital and interest mortgage a few years down the line.

3. Inflation can eat away at your debt. So if you borrow £150,000, when you come to repay it in 25 years, your debt could be worth significantly less in real terms. So, effectively, it's cheaper to pay off. 

4. House price inflation can benefit you if you have an interest-only mortgage. House prices more than trebled from 1995 to 2007, according to Nationwide - although of course they are now falling.

5. Flexible features are available on many mortgages now that allow you to overpay if you have extra money. If you have an interest-only mortgage, you can still chip away at your capital debt. Nationwide, for example, allows all borrowers to overpay up to £500 a month. This gives you the best of both worlds: you don't have a large commitment you have to meet every  month or risk losing your home - but you are still paying off your mortgage.

Five cons

1. Unless you put your money into an additional repayment vehicle, or sell the property, you may have no means of repaying your debt at the end of your term. And even then, there are NO GUARANTEES.

2. An investment vehicle may not grow by enough to repay your debt and you would be left with a shortfall that you would have to meet.

3. House price inflation may not follow the course you expect. Prices could plummet the year before you are planning to sell your property to pay off your mortgage.

4. If you are planning to sell your home in 25 years to pay off your mortgage debt, you will still have to live somewhere after you sell. How will you afford that, without taking out another mortgage? Downsizing is one option, but again, there is no guarantee you will be able to sell your home.

5. If you need to move or change your mortgage for any reason, you may find it difficult. While prices usually rise over the long term, there are short-term dips. If you get stuck in negative equity, you will find it hard to remortgage or move house.

Interest-only deals suit some people better than others. For example they might be a good option for:

• The disciplined who plan to remortgage to a capital and interest deal a couple of years later
• Borrowers with more than one property who have their other mortgage on a repayment basis, or own the property outright
• Buy-to-let investors who do not live in the property, and can benefit from Capital Gains Tax advantages with interest-only
• The self-employed or those whose income fluctuates as they can take low minimum repayments, with the option of overpaying in the good months.

However, borrowers who are not disciplined enough to switch to a repayment deal should stay away, as should those who don’t understand the full implications of an interest-only deal and do not have a plan for paying off the capital. Finally, borrowers who are still overstretching themselves to meet the mortgage repayments on an interest-only basis should think twice. And then choose a repayment option.

Safety first

Recent house price falls have shown that any assumptions people have had over the last few years about interest-only mortgages are flawed. They are a gamble, whichever way you look at it, which does not mean they are unsuitable for all, as some borrowers will be happy to take their chances.

But if you want a guarantee your mortgage will be paid off, a capital and repayment deal is the only way to go.

Use our mortgage calculator to compare the costs of interest-only and repayment mortgages.

Or compare mortgage deals at Fool.co.uk