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.
