The true cost of an interest-only mortgage

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The true cost of an interest-only mortgage

People tend to choose interest-only mortgages because they think they're cheaper than repayment (capital and interest) mortgages.

And in the short term, this is true.

You are repaying only the interest on the original sum borrowed known as the capital so the monthly payment is considerably lower than for a comparable repayment loan.

However, this is only part of the story.

Over the full mortgage term, you will end up paying significantly more interest than you would with a repayment mortgage, because you are not whittling away the capital you owe.

With a repayment mortgage, you pay this off as you go, so provided you keep up-to-date with the monthly payments, you will be debt free by the end of the mortgage term.

With an interest-only mortgage loan, you have to find a way of repaying this capital debt at the end of your term.

Unless you're expecting a substantial legacy or other windfall, this will involve setting up and making regular monthly payments into a suitable repayment vehicle.

For more on this, see Interest-only mortgages and our Quick guide to interest-only mortgages.

So how much will it actually cost?

Let's assume you took out a £150,000 interest-only mortgage at 6 per cent annual interest fixed for the entire 25-year term

(In fact, it's almost never a good idea to fix your rate for this long, but it makes the calculations simpler, so bear with us on this one.)

You would pay £750 interest a month giving a total bill of £225,000.

Meanwhile, you would need to be saving to repay the original £150,000.

Assuming you could find a safe, tax-free investment paying 6 per cent annual interest over 25 years and that's by no means certain you would have to put away £221 a month or £66,300 over the full term to amass the necessary cash.

That gives a combined monthly outlay of £971.

That means you would be facing a total bill over the 25 years of £291,300 (£225,000 and £66,300) to clear your loan.

Now let's assume you took the same £150,000 6 per cent mortgage on a repayment basis.

In this case, you would pay £966.45 a month, made up of capital and interest.

Provided you kept up with this repayment, by the time the 25 years were over, you would be guaranteed to be debt-free at a total cost of £289,935.

So going for the cheap interest-only option would actually have cost you an additional £1,365.

And that's if your tax-free investment returned the necessary 6 per cent.

If it failed to achieve this, you would be left with part of the capital debt still to pay, making the interest-only choice even more expensive.

An alternative: The part and part mortgage

If this has left you less keen on borrowing interest-only, but you still need to keep costs down in the early years, there is a possible solution.

It's called a part and part mortgage, and it combines features of interest-only and repayment loans.

To find out more, read about The part and part mortgage.

To read more on this subject please see the list below or your mortgage guide or your home buying guide

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