The Risks Of An Interest Only Mortgage

Mortgages and Home

Updated on 16 December 2008 | 0 Comments

A significant minority of interest-only borrowers may be heading for trouble when it comes to paying off their mortgage. Are you one of them?

The city watchdog, the Financial Services Authority, is warning homebuyers with interest-only mortgages to be very clear about how they are going to repay the loans they take out.

Nearly a quarter of all home loans are taken out on an interest-only basis but the FSA's research indicates that around 15% of borrowers have either no idea or no credible strategy in place for how they intent to repay the capital owed.

With an interest only mortgage, the total amount you owe is split into two parts - the interest and the capital sum. Each month you pay your mortgage lender only the interest you owe so your monthly payments will be lower than they would be for a repayment mortgage.

The lender ignores the original amount of the loan until the end of the mortgage term when they'll ask for it back in a lump sum. It is, therefore, up to you to make sure that by then you have the equivalent of the capital sum in the bank so you can pay them back in full. Usually, people will pay an additional sum each month into some form of investment product that is designed to achieve the required amount by the end date.

As you might imagine, an interest-only mortgage carries more risk in that the investment product might not grow enough to pay off the loan as many endowment policy holders have recently been discovering to their cost. However, it has the potential to grow even more than necessary - maybe even by enough to enable you to pay off the lump sum early or to have a little left over.

Personally, I have always preferred the straightforward repayment mortgage because it has the benefit of certainty. By the end of the mortgage term you will have paid back absolutely everything you owe and the house will belong to you.

Whether or not you opt for an interest-only or repayment mortgage, therefore, depends entirely on your attitude to risk. With the former you are effectively taking a gamble that you'll be able to pay off the mortgage at some point in the future without having to sell up while with the latter there's no question that you will end up fully owning your own home.

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