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You Are Here: Home > Personal Finance > Mortgages > Different styles > Interest Only Mortgage
Interest Only Mortgage

What are they - How they work - Pros & Cons

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Whether it's a discounted, a fixed rate, or tracker mortgage, they are all split into 2 distinct groups.

  1. Repayment style - part of the monthly payment goes towards paying the interest, part towards paying back the loan principal. So at the end of the term, usually 20-25 years, the original loan will be repaid in full

  2. Interest only - all the monthly payment goes towards paying the interest and at the end of the term (20-25 years) the original loan still has to be repaid
Interest Only Mortgage
So if you take out an interest only mortgage for £100k to be repaid over 25 years, at the end of this time the original loan will still be £100k and the lender will demand to be repaid. You'll then have 3 options -
  1. Remortgage into another £100k loan (assuming you can)
  2. Sell the property and repay the £100k mortgage
  3. Keep the property and repay the money back from your savings
Some people who take out an interest only mortgage also set up a separate savings/investment account which they contribute to every month and then use the balance to repay the loan. And most lenders will encourage this, but won't insist on it.

However, in reality most won't be able to do this as the reason they took out an interest only mortgage, rather than a repayment style, is that their budget won't stretch to the higher monthly payments that a repayment mortgage requires.

The difference in the monthly repayments
The table below shows the difference in the monthly payments of a repayment style mortgage versus an interest only one. For example, if you take out a £100k loan and the interest rate is 5% the monthly payment will be £591 (repayment mortgage) and £417 (interest only mortgage). And that is a significant saving.
Difference in mortgage payments : Repayment mortgage versus interest only style

Interest rate
Repayment mortgage
Cost per £10,000 borrowed
Interest only mortgage
Cost per £10,000 borrowed
3%
£47.90
£25.00
3.5%
£50.60
£29.20
4%
£53.30
£33.30
4.5%
£56.20
£37.50
5%
£59.10
£41.70
5.5%
£62.10
£45.80
6%
£65.20
£50.00
6.5%
£68.30
£54.20
7%
£71.50
£58.30
7.5%
£74.80
£62.50
8%
£78.10
£66.70
8.5%
£81.40
£70.90
9%
£84.80
£75.00
Both mortgages are for a period of 25 years

What's interesting to note is that when interest rates are low (under 4%) the difference between the 2 mortgage styles is significant. But with rates at 7%+ it starts to shrink dramatically.

So it's no surprise as UK interest rates have averaged under 5% for the last 10 years that interest only mortgages have been so popular. Also, high property prices, even though they're down from their 2006/07 peak, have forced many homeowners to take out interest only mortgages because the size of the home loan needs to be so large.

Interest only mortgages are far more expensive than repayment style

Most people think that an interest only mortgage is far cheaper than repayment style. And that's true if you look at the lower monthly payments needed to service the loan.

But in reality, over the long term, and never forget that a mortgage is a long term loan, repayment mortgages are far better value and cheaper, for example -

  • Take out a £150,000 repayment mortgage over 25 years at a fixed interest rate of 7%
  • The monthly payments will be £1,060
  • After 25 years the original £150,000 will be paid off
  • The total interest paid would be £168,051
  • Take out the same loan as above using an interest only mortgages
  • Monthly repayments would be £875 (£185 lower)
  • After 25 years the £150,000 would still be outstanding and the total interest rate bill would be £262,500 (around £95,000 more)
Total amount paid in interest : Repayment mortgage versus interest only style

Natural house price inflation must be considered

This is an important point to consider. Yes, if you take out an interest only mortgage over 25 years the original loan has to be repaid. But the price of the property (in 25 years) should also be taken into account.

Theoretically it would be possible to buy a property today for £100k using an interest only mortgage and in 25 years value of the property would be £400,000.

If so, even though the mortgage will have cost far more in monthly interest repayments (than repayment style) there would still be £300k of equity in the house and repaying or remortgaging the original loan wouldn't be that hard.

Points like these are worth thinking about, but it's also important not to assume that property values will rise significantly. Yes, property seems like a great investment, and it is if bought at the right price, but still it's no one-way street and many people have lost fortunes over the years, usually buying property when prices are high by historical standards, ie they bought towards the top of booms.

My point is that interest only mortgages are inferior products to repayment style. But if you take natural house price inflation into account (say +3% a year) these mortgages don't look as bad as some would have you believe.

How interest is charged
You'll have the choice of different interest rates, for example -
  • Fixed for a certain period of time, say 1 - 5 years
  • Variable, usually the lender's SVR which is normally the most expensive rate they charge
  • Discounted - look for these deals where the lender will offer say a 1% discount for a 1-2 years etc
  • More on Mortgage interest rates
Positives

  • Lower monthly repayments - It's an advantage in the short term but an interest only mortgage over the period of the loan is more expensive than a repayment style mortgages

  • Normally flexible - most interest only deals are flexible including the ability to cancel the deal and remortgage (high exit fees might be levied in the first few years of the deal). See Secret 3 - Buy simple and flexible - you can't read the future - which is one of this site's 10 Secrets to Good Personal Finance

  • Massive competition - always leads to some great deals as the lenders want business

  • Simple - when it comes to personal finance try to go with the simplest products and then the sellers can't hide anything

Negatives

  • No repayments made on the loan principal - think about how the original loan will be repaid at the end of the mortgage term

  • Total interest paid - although the monthly payments are smaller than a repayment deal the total interest paid over the term is far higher

Buying tactics, tips and tricks
Want the right mortgage at the best price? Then start by downloading our free mortgage guide and follow the 4 easy steps.
Who are interest only style mortgages best suited to

One group of people who tent to like interest only mortgages are those who work in a profession (doctors, lawyers, dentists, accountants etc) with an almost guaranteed chance of promotion in the future. And promotion normally leads to large salary increases.

So a junior accountant might be paid 25% of what he can hope to earn in 5-10 years. She might therefore take out an interest only mortgage with a plan to refinance it to a repayment style when her salary can afford the higher payments.

Consider a half-half deal - It's half better than an interest only mortgage

A half-half deal (or could be 75/25 etc) is where half the mortgage is interest only and half repayment style. For example, total loan of £100k, £50k interest only and £50k repayment. The advantage to this strategy is that a good proportion of the loan is being repaid.

Many lenders will also offer the ability to convert a set percentage of the deal overtime. For example -

  • Take out a £100k interest only mortgage today
  • After 2 years convert 10% of the loan to repayment
  • After another 2 years convert 15% of the original loan to repayment and so on
LearnMoney.co.uk comment :
Interest only mortgages are not bad financial products if you've done your research and understand the concerns discussed above, ie the original loan has to repaid at the end of the mortgage term. Also remember that they are more expensive than repayment style mortgages.

However, because of high property prices (even after the recent slump) some people are forced to use interest only deals because they can't afford repayment style. I can fully understand this strategy but if possible try to remortgage into a repayment style deal in the future.

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