Interest only mortgage

[FlorinCollector]

Hi my friend was telling me about interest only mortgages the other day that he had gotten into. Do any of you know the in's and out's? It all sounded like there is only advantages of this but there must be downsides? I was just looking for a deeper insight if anyone knows anything thanks. 

[HawkHybrid]

in my opinion:

 

interest only mortgage is when you only pay the interest

on a mortgage for the duration of the agreed term(time

period the mortgage last for). you then need to pay off

the whole mortgage sum when the agreement ends.

it's usually used to allow people to reduce payments in

the initial years of buying a home. my guess is it's

increasingly used to afford mortgages(home prices) that

would be too much if repayment of capital at the same

time as interest is required. it's a way of deferring the

risk of buying to the future. it can work in the case that

people have a guaranteed payment coming that will

cover the cost of buying but have to wait for a fixed date

for it to happen.

due to the fact that you owe the same capital sum

throughout the mortgage term, total interest paid is

larger in nominal value than capital and interest mortgages

because you're paying interest on a non reducing sum

throughout the term.

bottom line is if you can't afford the capital and interest

mortgage now then going interest only will only increase

the risk of the home being repossessed in the future. it's

not a loophole that provides a free lunch.

 

HH

[FlorinCollector]

On 26/11/2017 at 14:22, HawkHybrid said:

interest only mortgage is when you only the interest on

a mortgage for the duration of the agreed term(time

period the mortgage last for). you then need to pay off

the whole mortgage sum when the agreement ends.

it's usually used to allow people to reduce payments in

the initial years of buying a home. my guess is it's

increasing used to afford mortgages(home prices) that

would be too much if repayment of capital at the same

time as interest is required. it's a way of deferring the

risk of buying to the future. it can work in the case that

people have a guaranteed payment coming that will

cover the cost of buying but have to wait for a fixed date

for it to happen.

due to the fact that you owe the same capital sum

throughout the mortgage term, total interest paid is

larger in nominal value than capital and interest mortgages

because you're paying interest on a non reducing sum

throughout the term.

bottom line is if you can't afford the capital and interest

mortgage now then going interest only will only increase

the risk of the home being repossessed in the future. it's

not a loophole that provides a free lunch.

 

HH

However what if the price of the house is less than when you bought. I take it thats the biggest risk if you are left at the end owing a lot more? 

[Mark43]

Interest only mortgages had a bad press at one time. As HH stated the remaining lump sum still needed to be paid  off at the end of your 25 year mortgage. Unfortunately the usual method of paying this was via an endowment policy. Many  people suddenly found that the final valuation of this policy wasn't paying out what was required or that suddenly they had to top this fund up by a greater amount each month. Money they may not have had available or catered for. Not sure how popular these type of mortgages are these days.

[HawkHybrid]

what would they do if they can't get any renters for a

time period and the lender raises the variable rate of

interest it's charging on it's loans?

 

HH

[FlorinCollector]

On 26/11/2017 at 14:45, HawkHybrid said:

what would they do if they can't get any renters for a

time period and the lender raises the variable rate of

interest it's charging on it's loans?

 

HH

Thats what i thought to

[Xander]

44 minutes ago, JCRJM said:

Him and his mother are using them to then rent out. I was just thinking after the term they plan to sell to pay the bulk equity. However what if the price of the house is less than when you bought. I take it thats the biggest risk if you are left at the end owing a lot more? 

Would the banks/building society allow an interest-only mortgage for the purpose of letting, considering the risks involved with not knowing who is living in the property, after all, they own it until its paid for?

[FlorinCollector]

1 minute ago, Xander said:

Would the banks/building society allow an interest-free mortgage for the purpose of letting, considering the risks involved with not knowing who is living in the property, after all, they own it until its paid for?

Yeh its not interest free. Its interest only. Not sure if that was a mistake. But im sure the bank will know becausw they have been to a financial advisor to be speak about it as well. I was just wanting to know a little more about them as it didnt seem there was much downside but it seems there is quite a bit to think about.

[Pete]

An interest only mortgage means you are never paying off any capital just servicing the interest on the loan.
If you buy a property for say £300k using this method you will always owe £300k to the lender so effectively you don't own any part of the house or flat, the lender does.
Each month you pay the extras and never anything towards the property at all.
Bit like renting but you cannot walk away from the debt.

Say a couple of years later your interest rate rises then you will pay even more and still never own anything.

If property prices rise and in 10 years you plan to sell then when your buyer hands over say £400k then you pay back the original £300k from the proceeds and keep the difference ( profit ) less fees etc.
If however property prices stagnate or fall and you are forced to sell at say £250k then you will have no property AND still have to pay your lender £50k plus costs etc.

[Xander]

14 minutes ago, JCRJM said:

Yeh its not interest free. Its interest only. Not sure if that was a mistake. But im sure the bank will know becausw they have been to a financial advisor to be speak about it as well. I was just wanting to know a little more about them as it didnt seem there was much downside but it seems there is quite a bit to think about.

Well spotted, I'm doo-lally today.

I used to have an interest only mortgage back in the 90s. I had an endowment policy which was supposed to pay off the mortgage at the end of the agreed term, however, the endowment went belly up the result was I only received about 1/3 of the amount I should have. Fortunately the value of my property more the trebled which enabled me to pay off the bank. I would say that was just pure luck.

[Goldhooked]

51 minutes ago, Xander said:

Would the banks/building society allow an interest-only mortgage for the purpose of letting, considering the risks involved with not knowing who is living in the property, after all, they own it until its paid for?

Most buy to let mortgages are interest only.  However the lending criteria is much tougher these days.

I have a couple of rental properties but I won't be buying any more.  The government has already started hitting landlords harder with tax and I reckon it will only get worse.

[KDave]

Interest only mortgages are great during the rising market. But there is always the risk of falling prices. News of another 10 years expected of stagnant wages, and therefore little chance of property prices being increased from wage growth, plus plans for record numbers of houses being built over the same period, interest rates being historically low with sovereign borrowing levels rising, suddenly interest only reliant on capital gain doesn't look so good. Buy to let has other problems on top such as demographics and politics including brexit and growing numbers of renters who will vote in their own interest. The recent changes to buy to let are just the beginning in my opinion. House prices rising are a bad thing to a growing number of people who don't own, which is nearing that half way point and will exceed it in a few years should the trend continue. 

Anyways I thought buy to let mortgages nowadays require 50% equity from most banks? I would be surprised if the bank is allowing someone to take out interest only to buy to let in today's environment. Perhaps they are taking out an owner occupier io mortgage to then rent it out on the quiet?

[vand]

Don't even think about it.

They're the sort of loan that are popular at the height of credit bubbles because they make payments cheaper.. well of course they're cheaper if you're not paying off any capital.. duh.

If you have no idea about how to distinguish between principle and interest then imo you are not fit to be taking out a loan of any type. Creditors rely on people who can't make these sort of distinctions for the vast bulk of their profits.

[MoneyMike]

What are people's thoughts on interest only mortgages for house purchase?

The plan is to invest in an ISA to pay off the mortgage at the end of the term.  

Eg  house price 500,000 and deposit 200,000  - leaving 300,000 mortgage which I can use either repayment or interest only mortgage  

Repayment mortgage = c£1500pm based on c2% interest  

Interest only mortgage = c£500pm

By my reckoning, if I take out an interest only mortgage, and (a) pay the interest element of £500pm PLUS (b) invest £1,000pm into an ISA, then I am paying out the same money as the repayment mortgage. However, all I need to do is ensure that I invest sensibly to achieve at least a return equal to the underlying mortgage rate (currently 2%pa).  If I invest to match the underlying mortgage rate exactly then there is no difference between the mortgage types. HOWEVER, if I am able to outperform the mortgage rate, then the extra at the end of the term is profit. And of course if underperform there will be a shortfall.

I.e. If I can invest to beat the underlying mortgage rate, then I am better off going interest only. 

A quick google found a pure fixed interest cash ISA currently available for more than 2%, so I could take an extreme low risk approach and still be better off. Or I could diversify sensibly and still be pretty sure (!) of beating 2% significantly, albeit with increased risk. 

Am I missing anything? Thoughts?

[KDave]

Capital repayment is the least risky way to reduce the loan, guaranteed if meeting payments. Investing to pay it off is unnecessary risk. Investing to makes gains using money that is marked to pay off the mortgage is a gamble, calculated risk, speculation, ect. Choose you level of acceptable risk. 

Don't forget that with capital repayment any over payments you make reduce the total interest paid over the term. Not paying via interest only means you get hammered for the entire sum for the entire term, plus suffer any hikes in interest rates potentially. 

There are no rights and wrongs, only what is acceptable risk and thinking about dealing with the potential consequences. 

[MoneyMike]

Many thanks for your comments, good points. 

Agree repayment mortgage is less risk as guaranteed to pay off the full amount. But this guarantee comes at a (big?) price, namely the loss of investment returns over the mortgage interest rate.  I'm thinking perhaps the price is too high to stick with repayment mortgage. Investing over 25 years, while nothing can be guaranteed, 25 years is a long enough time frame to iron out short term wrinkles and to achieve a decent return. 

Re the point about not reducing the interest paid over the term, I think this all comes out in the wash and I'm not being hammered.  Agree I will be paying more interest, but on the flip side I will have the accumulated funds invested at that same (or higher) interest rate to compensate.  So I don't think this point is valid, and it all boils down to whether I can achieve investment returns over the mortgage interest rate, and the level of risk I take on to achieve this.

Do you agree that if I could always find a cash ISA paying the identical interest rate that the mortgage is charging me, then both mortgages are essentially identical?  (Just trying to establish our starting point)    

Finally, if mortgage interest rates go up, it would be expected that savings interest rates would rise similarly so I don't think that point is valid either.

Please do challenge everything I have said and let me know if you agree or disagree.  I have had repayment mortgages in the past, and this is a big decision for me whether to go the interest only route, so I need to have all the negatives clear in my head before I proceed...!

[HawkHybrid]

you are effectively borrowing money to invest with the

intention of making more money than the the rate of

interest you are paying. banks make money by borrowing

cheaper(your isa interest rate) and lending out at a higher

rate of interest(what they charge you to take out a

mortgage). if currently isa rate is equal or better than

mortgage rate I can't see this continuing for 25 years. on

a rate rise, banks sometimes raise their mortgage rates

more then they raise their isa rates.

I would do the sums and weigh out the risks for your own

personal situation. only that which is fixed by contract

will stay fixed. most things will change. work out what it'll

take for things to get ugly in each case and work from there.

 

HH

[reidpj]

3 hours ago, MoneyMike said:

What are people's thoughts on interest only mortgages for house purchase?

The plan is to invest in an ISA to pay off the mortgage at the end of the term.  

Eg  house price 500,000 and deposit 200,000  - leaving 300,000 mortgage which I can use either repayment or interest only mortgage  

Repayment mortgage = c£1500pm based on c2% interest  

Interest only mortgage = c£500pm

By my reckoning, if I take out an interest only mortgage, and (a) pay the interest element of £500pm PLUS (b) invest £1,000pm into an ISA, then I am paying out the same money as the repayment mortgage. However, all I need to do is ensure that I invest sensibly to achieve at least a return equal to the underlying mortgage rate (currently 2%pa).  If I invest to match the underlying mortgage rate exactly then there is no difference between the mortgage types. HOWEVER, if I am able to outperform the mortgage rate, then the extra at the end of the term is profit. And of course if underperform there will be a shortfall.

I.e. If I can invest to beat the underlying mortgage rate, then I am better off going interest only. 

A quick google found a pure fixed interest cash ISA currently available for more than 2%, so I could take an extreme low risk approach and still be better off. Or I could diversify sensibly and still be pretty sure (!) of beating 2% significantly, albeit with increased risk. 

Am I missing anything? Thoughts?

You may find the lending criteria for residential interest only mortgages quite onerous.  Residential mortgages are highly regulated compared to buy-to-let (which are becoming more regulated by the minute).  

e.g.

 

 

[MoneyMike]

Thanks guys, great stuff. Good to have all these viewpoints. 

HawkHybrid, good points, acknowledged. Unlikely I can outperform by investing in cash ISA's. In reality I would invest in something a little more aggressive than that, for example a combination of active and passive funds and widely diversified. Over the long term, I would be fairly confident about outperforming mortgage interest rates.  My initial decision is for the first two years only really, as I would get fixed 2 year rates and then remortgage. I can reassess at that point, but likely I would stick with interest only as difficult to guarantee outperformance in the short term. 

Reidpj, agree interest only can be hard to get for residential, but my broker says he has spoken with the mortgage company and they would accept my application on interest only basis based on my circumstances and LTV...

more viewpoints welcomed! ?

[reidpj]

Double/triple check that the mortgage company will provide the finance; they have been known to change their minds (or their lending terms) before releasing funds - even after you have incurred costs (valuations, legal fees, etc).

Re-mortgaging after 2 years may prove to be expensive when all the fees (valuation; legal; broker; set up; exit; etc.) are taken into consideration.

[KDave]

How long can you fix the interest only mortgage? This is the variable by which you will be hammered imo. Pay down the debt so that when/if rates rise this doesn't happen. If you could fix for 25 years say and invest over that time frame but would need a decent return to achieve the higher interest rate on the longer fix. I have not done the math but look into it and work it out on paper, then you can see if it works. If it's break even what's the point taking the additional risk?

Honestly if you can make it work on paper and are willing to give it a go do it. If you get chance read some of the other threads I have explored this idea myself as I have a very low interest mortgage (repayment) and looked into investing vs over payments. The issue for me was the short time frame of 5 years fixed which in investing terms is not long enough to iron out the bumps when they happen. Because knowing my luck the market would crash at 4 years 11 months into the term accompanied by interest rates rising to historic levels. Hammered. 

I would rather have the certainty of lower wealth lost to interest than the small chance to make gains in a market at historic highs but each to their own. 

[MoneyMike]

Decisions!!!

KDave, I'm chatting to my broker tomorrow to find all the exact details and options, but I'm likely to only be fixing for two years. Regarding future interest rate rises,  I believe there are always investments that can outperform mortgage interest rates, for example moving from equities into a mix of corporate or government bonds along with a small selection of riskier assets such as derivatives.

You say to do the math and work it out on paper, but imho that is impossible as the underlying theory is simply can I earn a higher return than the underlying interest rate?  If I can, then I'm in profit (as compared to repayment mortgage). If not, I'm in loss.  I won't know for certain until it happens. 

For example, Say half way through the term, mortgage rates rocket to 20%:

1. If I had gone repayment, then my loan would have reduced and I would accordingly pay less interest than on a full loan. But I will have no cash in the bank.

2. If I had gone interest only, then my loan outstanding would still be the full amount, so I would owe 20% on the whole lot. However, in this case by this time I will a portion of the original loan balance invested, and if market interest rates are 20% then there will be suitable bond investments giving me 20% on that portion, which will compensate me for the higher interest rates. 

Under (2), at any point I still have the option to pay off part of the mortgage with the money I have accrued at that point, which would be me in the same position as (1). 

So it all boils down to whether I can exceed 20% investment return, which I believe I can, as I have flexibility and can take more considered riskier investments which over the long term "should" outperform.  Yes it is a risk, which is why I likely wouldn't go full equity based investment but a fully diversified and relatively safe strategy.

It has been mentioned that shares are at an all time high. The trend for shares, over a long period (20years plus), has always been upwards and is very likely to continue upwards. I think I would struggle to pick two dates twenty years apart in history where the stock market hasn't made a better return than mortgage rates (if anyone can point me to any evidence for or against this theory I would be very appreciative!). 

Finally, I always have the option and likely plan of downsizing at or part way through the 25 year term, which would release some equity from the property.

Im pulling the trigger soon (next couple days), so advice or devil's advocate comments will help! 

In reality, I may chicken out and compromise with a part and part mortgage. ?

[KDave]

Good points.

Consider how much you can repay on the io mortgage at once, there may be a limit after which charges are involved, which needs to be accounted for in return from the investment portfolio. If rates rise and you need to reduce owed capital this may affect whether you break even.

Shares are not always upwards over long periods. If you are averaging in with monthly accumulation then the risk of catastrophe is lower, but look at the historical tops - how long it took for shares bought then, to break even again, it took decades after 1999. Historic highs again. 

Please speak to someone who knows what they are talking about (not us lot on here ) before you pull any triggers. 

[MoneyMike]

Thanks KDave. I would be planning to continually remortgage each time an initial period expires to keep getting the best rates rather than SVR. Therefore any capital repayment would be at this time and not subject to any major charges.  Of course, there are remortgage costs, but think these are a necessary evil and a lot of companies do good deals on remortgaging with the same lender (eg free valuation, fee free, cash back, etc). 

Re stocks and shares, even if I had invested the whole lot in 1999 at the height of the tech boom then we are less than 20 years from there and the market is back at historic highs.  But as you say, I will be trickling money in monthly which will dampen my exposure to fluctuations, plus will be heavily diversifying into some assets/funds uncorrelated with the equity market to further dampen equity swings. 

On a separate note, I own my own company, so going the interest only route allows me to increase my company pension contribution rate, and use the extra pension fund generated as one method of repayment - this is more efficient tax wise.

[KDave]

Yes that may be a tipping point if tax efficiency is involved, this is an area that can be measured and reduces uncertainty, it is a guaranteed gain. Are you looking into paying for advice given the complexity we are dealing with here? It is probably money well spent with the sums involved with a mortgage?

My situation is different in that I already had capital repayment, but the tipping point for me was that I could guarantee my position in 5 years by overpaying, known saving in interest (see it as a small gain perhaps), more importantly, bringing forward the time at which cash flow is increased by the mortgage amount plus over payments by years. Bear in mind I make small allowance for a pension (with tax advantage, a sipp) to hedge my bets, I am not so confident of a market crash to avoid stocks all together, nor am I so confident it won't, hence the obsession with gold. 

I am also somewhat risk averse and like to diversify and keep leverage low. Borrowing to buy a house with large amounts of leverage then investing with the repayment capital would give me trouble sleeping, which probably means the rewards will be huge and I have missed out 

Let us know what you decide and how it goes.