What's wrong with an interest-only mortgage?

Is taking out an interest-only mortgage really a savvy way to cut your monthly payments? Or are you embarking on a dangerous short-term strategy with costly long-term consequences?

How an interest-only mortgage works

First of all, you need to know how an interest-only mortgage works.

With any mortgage, you have to pay back the capital debt (the sum you actually borrowed) and you have to pay interest on that debt (so the lender makes a profit from lending you the money... that's right, they don't do it out of the kindness of their hearts).

With a repayment mortgage, you spread the repayment of the capital debt and the interest into even monthly payments over the course of the mortgage term. So, if you take out a 25-year mortgage, at the end of those 25 years, your mortgage is guaranteed to be paid off.

With an interest-only mortgage, you only pay back the interest on the mortgage every month. This means that you can cut your annual payments by thousands of pounds.

Sounds great, doesn't it? The only problem is, the capital debt is still outstanding. In other words, you haven't actually paid back any of the amount you originally borrowed. You didn't forget about that, did you?

If there's one thing you can be sure of in this world, it's this: the mortgage lender will not forget. And, at the end of the mortgage term, it will ask you to pay it the money back. So if you borrowed £100,000, it will present you with a bill for £100,000.

Interest-only vs repayment

Let's look at an example. Say you've got a £100,000, 25-year mortgage, with an interest rate of 5%.

With a repayment mortgage, your monthly mortgage repayments will come to around £591.27. On an interest-only deal, that would fall to £416.66. So over the course of a year, you've cut your repayments by almost £2,100.

Over the course of the 25-year term, you've 'saved' £52,375. But then at the end, unlike a repayment mortgage, you will suddenly have to pay the lender a £100,000 lump sum.

So, overall, as the table shows, you'll be almost £50,000 worse off.

Costly consequences

How does this work? Why does an interest-only mortgage cost more, overall? This is where it gets a bit technical, so take a deep breath and bear with me. The reason an interest-only mortgage works out more expensive over the long-term is because, if you do not pay back any of the £100,000 capital debt, the lender will charge you interest on the entire loan for the entire term.

By contrast, with a repayment mortgage, you are trying to get rid of your debt from day one and gradually chip away at it on a monthly basis until it's all gone.

So with a repayment mortgage, every month, the total amount you owe the lender gets smaller. In turn, this means that, every month, the amount of interest you have to pay gets smaller -- saving you £50,000 in interest payments over 25 years.

Always a bad idea?

Now, it probably sounds like I'm totally against interest-only mortgages. I'm not. If you're stretched financially, desperate to get on or move up the property ladder and confident your income will soon go up, then an interest-only mortgage may not be such a bad idea. That's as long as you understand the extra costs involved.

But the moment you can afford to meet the higher monthly payments on a repayment mortgage my advice would always be: switch.

Do not, whatever you do, rely on an increase in the price of your property to pay off the capital debt at the end of the mortgage term. Never mind the fact that betting on the property market is a huge gamble, just remember that this strategy means you will have sell your home and move out.

And where will you move to? Every other property will have increased in value as well. You may well find you cannot afford to buy without taking out another mortgage.

Basically, opting for an interest-only mortgage is a bit like leaving an open wound to fester. If you decide not to deal with it today, you can save yourself a bit of pain and hassle now. But the longer you leave it, the worse it will feel. And you alone will pay the price for putting it off.

This is a lovemoney.com classic article, updated for 2012.

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This article aims to give information, not advice. Always do your own research and/or seek out advice from an FSA-regulated broker (such as one of our brokers here at lovemoney.com), before acting on anything contained in this article.

Finally, we tend to only give the initial rate of a deal in our articles, but any deal which lasts for a shorter period than your mortgage term may revert to the lender's standard variable rate or a tracker rate when the deal ends. Before you take out a deal, you should always try to find out from your lender what its standard variable rate is and how it will be determined in the future. Make sure you take all this information into account when comparing different deals.

Your home or property may be repossessed if you do not keep up repayments on your mortgage.

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