The Interest Only Survival Guide

More of us are opting for interest-only mortgages. These can be dangerous for your finances but they can be used safely too.

Over the last few years, more and more of us have been taking out interest-only mortgages. Five years ago, they accounted for just 13% of home loans. In June of this year, this figure had risen to 31%.

While that seems like a huge leap, it's worth noting that the way these figures were calculated by the Council of Mortgage Lenders changed significantly in 2005, causing a rise from 16% to 27% in one fell swoop. So the actual increase isn't quite as sharp as it might first appear, but they are certainly getting more popular again.

Interest-only mortgages are more risky

Interest-only mortgages are inherently more risky than repayment mortgages for two reasons.

Firstly, the amount you pay changes by a greater amount than a repayment mortgage when interest rates go up or down. This is because you're always paying interest on the full amount outstanding, whereas with a repayment mortgage your balance decreases steadily over time, meaning the interest element is calculated on a lower average amount.

Secondly, you're not guaranteed to pay back the original amount you borrowed. In theory, you invest a separate amount in an investment plan. In the past, many people have invested money in an endowment to pay off the loan, only to find that the endowment hasn't performed as well as expected.

Or you can make occasional lump sum repayments to reduce the capital amount. This could be when you've received an annual bonus, for example.  This is what I've done.

A small proportion of people take the ridiculously risky approach of not putting anything aside, assuming that they will be able to trade down at the end of their mortgage term and use the proceeds raised to pay off their original loan. This might work if house prices grow rapidly over the next couple of decades but that's a huge gamble to take.

Other people are taking halfway house approaches. Either they are using a mixture of repayment and interest-only loans; about 6% of mortgages are of this type. Or they plan to have an interest-only mortgage for a few years and then switch back to a repayment. This is fine, provided you have the discipline to do it!

Are we are at a crisis point?

There are reports that many people coming out of short-term fixed mortgages are opting for interest-only mortgages so that their monthly repayments are more manageable. If true, it doesn't bode well.

The difference between the two payment options can certainly be significant. A £150,000 loan over 25 years at 6% costs £750 a month for an interest-only deal. The repayment option will set you back £966 a month - more than £200 more.

While it's true the proportion of interest-only mortgages is increasing, it is from a relatively low base, and it's still a lot lower than it has been in the past. There is data on this going back to 1974, although it's less reliable for earlier years. Up until the early 1980s, interest-only mortgages were about as popular as they are now.

Then came the rise of the dreaded endowment! It reached its peak in 1988 when 83% of mortgages were interest-only.  Interest-only mortgages continued to be more popular than repayment ones until the year 2000.

So we're certainly not in uncharted territory. Nevertheless looking back to the era of endowments for comfort is hardly inspiring -- we all know how that turned out!

Surviving with interest only

Like many financial products, there is nothing inherently wrong with interest-only mortgages. As long as you appreciate where the risks like, they can be controlled.

The most recent figures split down interest-only mortgages into those with and without a specified repayment plan. Interestingly, those without a plan vastly outnumber those with one. For first-time buyers it's by a factor of three to one. For home movers, it's four to one.

Again, this is not necessarily a bad thing. Personally, I don't like the idea of investing to pay off a mortgage. I prefer the certainty of making repayments as and when I like. This also reduces your monthly interest bill, which is always a pleasant feeling.

Of course, we don't know how many of those without specified repayment vehicles are making proper provisions elsewhere. However, we do know that investment plans need to be closely monitored and can easily fall short. As endowment holders have discovered, once you lose ground it's very hard to recover.

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More: Psst! Some Mortgages Are Getting Cheaper