Interest-Only Mortgages For First-Time Buyers

Interest-only mortgages can be a useful tool for first-time buyers but they carry additional risks.

Not too long ago I wrote about buying with a repayment mortgage versus renting. I showed that, whilst it is worth owning your own home, it doesn't make sense to rush in panicking like an old, wisened sage, used to the adoration his counsel brings, who's just ran out of good advice. Better yet, don't rush in like a young, wisened sage, because they probably rush around and panic more frantically.

I then urged first-time buyers to take the time to find a good deal, and to go for the shortest possible mortgage. Now I'm going to do the same comparison with interest-only mortgages, which are usually used for short periods as a cheaper way to get on the property ladder.

Interest-only mortgages cost less than repayment mortgages on a monthly basis, but they can cost more in the long run. If you just pay the minimum payment, it doesn't contribute to you owning the property outright, it just pays the interest on the loan. This makes you particularly vulnerable to a downturn in the housing market, as you could find yourself with a property worth less than your mortgage.

The deposit buffer

Getting a mortgage with a deposit of, say, ten or fifteen percent gives you a nice buffer from short-term downturns in house prices, especially in today's market, which has demand exceeding supply. Even so, the market isn't invincible. And don't forget you have to raise the deposit. If you choose not to, and buy a 100% mortgage (i.e. you don't have a deposit), you look very vulnerable to falling house prices in the short term.

Buying a property as a home

Using my own personal circumstances, it's much more expensive for me to buy a home with an interest-only mortgage than to keep renting. I worked out that my mortgage, plus all the extra costs of being a homeowner would increase my monthly household outgoings by more than 40%. If interest rates went up, it'd be even more. (Well, duh!)

However, this won't be the case for everyone. Let's look at what is probably a typical first-time hopeful: a 28-year-old paying £400 a month in rent for a fair, two-bedroom flat in East Anglia. He wants to buy a similar flat with an interest-only mortgage, then sell two years later, using the profits as a deposit for a bigger property for him and his girlfriend.

So he buys a better flat costing £130,000, which, according to Halifax's latest house price report, is about average for the region. He pays a 10% deposit of £13,000 and gets a 25-year interest-only mortgage of £117,000. He can get a lot of good discounted variable rates, as shown here:

Taken from our mortgage centre

If we (very!) optimistically presume that interest rates don't rise, the monthly cost of the mortgage is little more than he was paying in rent.

After two years, let's say that house prices have risen at 4% per year, which means the property is worth £140,608. Now, even if you add on the extra costs involved in buying the property, such as legal fees, and also the costs of being a homeowner, such as property repair , furniture and home improvements, he should have made a small to medium-sized profit. Plus any home improvements might have increased the value of the property further.

So it does appear to work for some people, and even more so for couples. However...

Dangerous assumptions

Our friend in East Anglia, much like many first-time buyers, wanted to sell in two years. If we look at any long-term graphs of house prices we see that since 1983 we've been in a property boom, but this doesn't mean that prices have always gone up during this period. Nor does it mean they will always go up in the future. All markets rise and fall, after all.

Let's not forget the housing market in the late 80's throughout most of the 90's. According to data from the Halifax, UK property prices fell from a height in 1989 of £69,850 to a low of £61,115 in 1995. This is a fall of 13%. Looking at one of the particularly bad two-year periods in that time, house prices fell a little over 10%. It's worse for East Anglia, where prices slumped from £86,493 in 1988 to £57,200 in 1993, a fall of 35%! This would wipe out our friends deposit and then some. Also, house prices didn't recover until the end of 2000, which means a wait of 12 years to break even.

So what we must remember is that we can lose from the housing market, even today's one. Falling markets can -- and usually do -- occur when people least expect them. Property is an excellent investment - it does make sense to buy. But we should think of our homes first and foremost as homes, not investments, especially not short-term investments. We shouldn't take on mortgage debts greater than we can afford simply to get on the property ladder. Even if we can afford it, if we intend to buy and sell within a few years, then interest-only mortgages might not be for us.

You can compare mortgages quickly and easily with our Mortgage Service.