Interest-only mortgages have fallen out of favour in the last ten years, following the credit crunch and the introduction of more responsible lending practices.
It used to be fairly common to take on an interest-only mortgage alongside an endowment. This kept monthly mortgage payments low, with the aim of building up an investment fund to clear the balance.
Providing investment growth was positive, there was always a possibility of having a little left over once the mortgage was cleared.
Of course, it didn’t quite work out that way, with many investors experiencing a shortfall, and needing to find other ways of repaying their mortgage.
Part of the issue was the lack of investment choice. Most endowments were invested in life company with-profits funds. These offered a ‘one size fits all’ investment approach, with individual investors having no control, and very little insight into where their money was invested.
In today’s market, investors can invest in any fund, share or investment trust that suits their requirements. Investing is simple, cheap and easily accessible. While investments can be volatile and growth is never guaranteed, it is not unreasonable to expect average returns of 3-7% per year over a 20 or 30 year mortgage term.
With most mortgage rates under 3%, the maths behind interest-only mortgages certainly stacks up. So, with today’s investment choice eliminating many of the issues behind the endowment crisis, is it time to consider interest-only mortgages again?
The Benefits of Interest-Only
Interest-only mortgages are appealing for the following main reasons:
- As you are only paying the interest on your mortgage, the monthly commitment is lower.
- Historically, equity growth has been ahead of mortgage interest rates. In theory, this means that someone with an interest-only mortgage and a suitable investment would have been better off than someone else who prioritised clearing their mortgage. Of course, there are many variables to this, and it would not be the case in every situation.
- For an investor with a high risk profile, the possibility of building up a higher investment pot may be more attractive than the certainty of clearing a mortgage.
- Interest-only mortgages are particularly well-suited to buy-to-let investors. This keeps the costs down, maximising profits from the rental income. It is also more likely that the property will be sold at some point, allowing the balance to be cleared.
The Case Against
Of course, interest-only mortgages aren’t for everyone. As with everything in the financial world, it is a case of balancing risk and potential reward to arrive at the best solution.
Interest-only mortgages have the following disadvantages:
- If interest rates rise, it may not be possible to save as much each month. Ultimately, this could result in a smaller fund value that isn’t enough to clear the mortgage.
- Investment growth may be lower than expected. Over the long-term, investments have generally moved in an upward direction. However, if a market crash occurs just before you need to withdraw the funds, or you take money out early and miss out on the recovery, you may be at risk of not being able to pay off the mortgage.
- A repayment mortgage allows you to build up some equity in the property. Even if the repayments become unaffordable or your circumstances change, you will be in a more secure position if you have reduced the amount owed.
- For an investor with a lower risk profile, the certainty of clearing the mortgage may be preferable to the prospect of building up a larger investment pot.
- Interest-only mortgages are not as widely available as repayment mortgages, which means the rates may not be as competitive.
- The investment will need careful monitoring. Any of the following could impact your plans if adjustments are not made:
o Not reviewing your investment contributions to check you are still on track to meet your target.
o Borrowing more money and not increasing your savings to compensate.
o Taking too little risk with the investment in the early years, reducing the growth potential.
o Taking too much risk in later years, exposing the fund to potential losses at the point you need to withdraw the money.
o Interfering too much with the investment strategy. Trying to time the market or making investment decisions influenced by emotion are usually detrimental to returns.
o Taking money out early, with the intention of replacing it later.
An interest-only mortgage may be suitable for you if:
- You have the assets to pay off the mortgage if necessary; or
- You can afford to save substantial amounts each month; or
- You are a buy-to-let investor and are not at risk of losing your home if things don’t go as planned; and
- You have the tolerance and capacity for risk to deal with potential investment volatility.
Top Tips for Interest-Only Mortgages
- Don’t rely on selling the property to pay off the balance, especially if this is your home.
- Save regularly into an investment plan with the aim of clearing the balance at the end of the term. If growth is ahead of expectations, or you decide to sell the property, you will have an extra pot of money to use for other purposes.
- Overpay the mortgage annually if you can.
- Shop around for the best interest rates.
- Make sure you have an emergency fund and adequate protection to deal with any unforeseen circumstances.
Please don’t hesitate to contact a member of the team if you would like to find out more about your mortgage options.