Interest-only mortgage deals

by Jane Baker on 26 April 2010  |  10 comments
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An interest-only mortgage might seem like the obvious choice for cutting your costs, but it’s not as cheap as it seems.

Whether you’re buying your first home, remortgaging or moving to a new home, getting the right mortgage every time is one of the most important financial decisions you’ll ever make. But this decision isn’t always clear cut, and making the wrong choice can have a huge impact on your finances for many years to come.

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Interest-only mortgages do exactly what they say on the tin. Your monthly payments to your lender just cover the interest on your loan. They don’t repay any of the capital you owe. So the amount you pay each month is considerably lower than a repayment mortgage where you repay the capital amount and the interest at the same time.

For this reason, interest-only mortgages might look attractive, but they can be a lot pricier than they seem. Let’s take a look at how they really compare with repayment mortgages.

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Interest-only versus repayment: how much will it cost?

Imagine you need to borrow £150,000 over 25 years and your mortgage rate is 4.19%. The table below shows the monthly repayments for each type:

By going down the interest-only road, it looks like your monthly outlay costs just £521.99 and would save you more than £3,386 in just one year alone.

But choosing an interest-only mortgage in preference to repayment isn’t a no brainer because these figures don’t tell the whole story. In this example, your monthly payments of £521.99 only cover the interest on your mortgage loan. The capital amount you have borrowed - that is, £150,000 - is still outstanding, and will need to be cleared at the end of the mortgage term.

Interest-only mortgages should run alongside a repayment plan such as an endowment or an ISA. The idea is your repayment plan will increase in value during the mortgage term, and will grow sufficiently to repay the capital sum in 25 year’s time.

If you use a stocks and shares ISA to build up a sum large enough to repay the capital, how much would you need to invest? Take a look at these figures:

So you can see, depending on how well your ISA grows, you could need to pay an extra £190.49 to £293.83 every month - on top of the interest-only repayments you’re already making - to fully clear your mortgage after 25 years. That means your total costs each month could fall between £712.48 and £815.82.

If your ISA only grew by 4% a year, your monthly spend would actually be higher than the equivalent repayment mortgage, all things being equal. But this leads to another problem: You’ll have absolutely no idea how well your ISA will perform, and therefore it will be difficult to judge how much you should invest each month to reach your capital target.

Suddenly interest-only mortgages don’t look quite so simple after all.

And the problems don’t end there...

Extra interest

Recent question on this topic

• billykeats asks:

  Should I overpay on my Interest Only mortgage?

  • 
    SoftwareBear answered "How do you plan to clear the capital sum at the end of the mortgage ? Are you going to use the..."
  • 
    MikeGG1 answered "You will be paying 2.94% but interest rates are liable to rise in a few months. I would top up..."
  • Read more answers

Interest-only will cost you more in the long run for another reason. Given that the capital won’t be repaid until the end, interest is payable on the entire debt throughout your mortgage term. However, with repayment mortgages, interest is only charged on the reducing debt.

Let’s see how that might work in practice: You choose a competitive tracker deal with a pay rate of 2.49% (BBR + 1.99%) which reverts to an existing borrower’s rate of 4.24% for the rest of the term. I’ll assume all rates stay the same throughout.

On an interest-only deal your repayments start at just £311.25 during the introductory period. But on a repayment basis it would cost considerably more at £672.17 (based on a loan of £150,000).

But how much would these loans set you back in total over 25 years? The true cost of the repayment option would be £239,115.72 (including all fees), while the interest-only mortgage costs £305,550 including the additional £150,000 in capital*. Putting it another way, the interest-only loan actually costs you an extra £66,424.28.

Interest-only rates are rising

And there's more bad news. The example above is based on a deal where the pay rates are exactly the same for both interest-only and repayment mortgages. But it looks like lenders are becoming less inclined to take on the extra risk associated with interest-only loans.

Halifax, the UK’s largest lender, has just introduced a new range of mortgages which are available exclusively on a repayment basis. Borrowers who wish to take out an interest-only loan will be hit with pay rates that are 0.20% higher for the same tracker and fixed-rate deals.

If this is the shape of things to come, interest-only mortgages will only become even more costly.

So you can see choosing the right mortgage can be a minefield. If you need help, don’t forget you can speak to an independent, fee-free broker using the lovemoney.com mortgage service.

More: Get a cheaper mortgage while you still can | My favourite mortgage

At lovemoney.com, you can research all the best deals yourself using our online mortgage service, or speak directly to a whole-of-market, fee-free lovemoney.com broker. Call 0800 804 4045 or email mortgages@lovemoney.com for more help.

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 will revert to the lender's standard variable 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.