Broadening Horizons: An Introduction to Interest-Only Mortgages
By Folu Majekodunmi for House of Henley
In simple terms, an interest-only mortgage allows you to only pay the interest on the loan/mortgage you take out, and not repay the amount borrowed until the end of the term.
The difficulty is, residential interest-only mortgages are difficult to get. Typically lenders will only allow you to borrow 50% of the value of the property, and they also only tend to lend to high net worth individuals making over £100,000 a year. However, these rules tend to be less strict for buy-to-let mortgages, because the borrower is expected to be making rental income from the property.
Repayment vs interest-only mortgages
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Nowadays, you can get repayment loans with a 40-year term which reduces your monthly payments; however, you will still end up paying over 2.31 times the value of the property by the 40th year (based on a 5% interest rate). You will own the property now which is most people’s goal, but for a £500,000 house, you will pay £1,157,272 according to London & Country.
The amount payable on a repayment mortgage is £2411 per month compared with £2085 on an interest-only mortgage, so interest-only provides a saving of £326 each month, or £3912 a year. If you were to put the £326 a month in an investment that makes 7% per annum compounding then, after 40 years, you will have £865,998.21. This would pay off the money borrowed and more. It is not unreasonable to expect a stocks and shares ISA to deliver this return. Last year, for example, ‘Vanguard life strategy 60% equity’ showed a return of over 15% after fees.
A book I recently read gave the example of a man who purchased a house in 1967 for £3,500; he decided to take out a 25-year capital repayment mortgage and put down a deposit of £1,000. Each day he worked to pay his mortgage of £17.87 a month, which at the time was 40% of his salary. In 1992 he made his final payment and now owned the house outright. If he had decided to take out an interest only mortgage his monthly payments would have been £12.50. That extra £5.27 a month would have been an additional holiday for him and the family in those days, as he had described. When asked if he would have been able to pay the £2,500 balance in 1992, he replied “it would have been one pay cheque, I haven’t really thought of it like that.”
The power of inflation
We tend to forget how different the value of money will be in the future, and when you are taking out a mortgage or loan, you should absolutely consider the effect inflation will have on it. Times have changed though. In the example above, the amount outstanding was £2,500 or one paycheque for our buyer in 1992; however, nowadays the amount outstanding would be closer to £500,000. Hardly one paycheque.
Indeed, according to inflationtool £100 in 1980 is equivalent to £394.11 today. That would suggest that someone on £120,000 today would be making £472,932 in 40 years, if inflation rates were the same over the next 40 years as they were over the last 40 years.
When interest-only might be right for you
If you are able to secure an interest-only mortgage, and you use the monthly savings to invest in a disciplined way then, at the end of the term, you may well be in a position to pay off the repayment amount and be in a stronger position financially too. You may even be able to purchase an additional 1 or 2 investment properties to help fund your retirement.
There is always risk with investing, but over 25-40 years of sensible decisions, I am confident you will see returns. I also remain bullish that property is one of the strongest asset classes.
The purpose of this post hasn’t been to give you specific financial advice. It isn’t financial advice. It is simply a nudge to show you that, for many, taking out a mortgage is a case of applying to a bank and seeing what they can get. This may well still be the best option for you; however, when taking such large financial decisions, you should be aware of all the options available – including interest-only mortgages. You should also be aware of how inflation affects your mortgage and how you might be able to make investments with any monthly repayment savings that will benefit you in the future.
Please comment below to let us know your thoughts.
Disclaimer: Nothing in this post should be construed as, investment, tax or financial advice. It is recommended you seek specialist independent tax and financial advice before taking any financial decisions.
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