Interest Only Mortgages

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Interest-only loans are a popular way of borrowing money to buy an asset that is likely to appreciate in value and which can be sold at the end of the loan to repay some or all of the capital.

A good example of where interest-only mortgages are used are for the purchase of second homes, or buy-to-let (investment) properties.  In the UK, the 1980s and 1990s saw the rise in popularity of endowment policies, as a way to buy a house and the plan was to combine an interest-only loan with an regular savings plan (usually with a life insurance element) that was invested by an insurance company. The plan was that the endowment policy would cover the mortgage and provide a lump sum in addition.

Many of these endowment policies were poorly managed and failed to deliver the promised amounts, some of which did not even cover the cost of the mortgage. This mis-selling, combined with the stock market declines, resulted in endowment mortgages becoming unpopular.

Although some endowment policies are still sold, there are many other methods that can be used to pay off the outstanding capital at the end of an interest-only mortgage term.

Interest Only Mortgage Repayment Methods

• ISAs (and PEPS) - for example, the difference in monthly payments between a repayment and an interest-only mortgage can be invested into an ISA each month
• Pensions - contribution with tax relief can be made into a pension and then a tax-free lump sum can be used to pay off part or all of the outstanding capital at the end of the interest-only mortgage term
• Sale of Property - where the home owner hopes to sell the home for a higher value than it was bought for at the beginning of the mortgage term and use this money to pay off the lender.  The amount remaining could be used to help purchase a smaller (less valuable) property
• Sale of Assets - The borrower may have other assets that can be sold to pay off part or all of the outstanding balance at the end of the mortgage term.  These assets could include stocks & shares, collectable art / vehicles etc.
• Endowments - endowment plans have lost popularity since the 1990's due to many plans not covering the outstanding capital on maturity and are a life insurance contract designed to pay a lump sum after a specified term (on its 'maturity') or on earlier death.
• Inheritance - some people wish to rely on inheritance (e.g. from relatives) to repay the outstanding capital at the end of the mortgage term

Since the credit crunch of 2007/2008 banks have tightened their lending criteria and this has affected the residential interest only mortgage market too.  Banks now require borrowers to show how they plan to pay off the outstanding capital at the end of an interest only mortgage term.  Hoping for inheritance or planning to sell the property at the end of the term is rarely accepted now - banks want to see some kind of savings / investment plan set up.

N.B. lenders tend to be more flexible for interest only mortgages taken out on investment / buy-to-let properties as these are not the investors place of residenrce and currently, buy-to-let mortgages are not regulated by the FSA

ISA (and PEPS)

ISAs (individual savings accounts) and PEPs (personal equity plans) can be used to save up money to pay off all or part of the outstanding capital at the end of an interest only mortgage term. This could be using old money that has been invested, setting up a new plan, or a combination of both.

An example could be saving the difference between a monthly repayment mortgage and an interest only mortgage in an ISA (note that PEPs were replaced by stocks & shares ISAs in 1999).

ISA Mortgage Repayment Example

To find out how this could work, below is an example of someone taking out a mortgage for £125,000 on an interest-only basis at a 5% interest rate for a term of 25 years.  They would then use the difference between what their payment would be if it was a repayment mortgage and invest that amount in a stocks & shares ISA.

Repayment monthly payment: £730.75
Interest-only payment: £520.83
Difference: £209.92

If you invested £209.92 each month into a stocks and shares ISA and averaged a return of just 5% annually, then when compounded over 25 years, you would have an account worth: £125,009.40.  This covers the outstanding capital at the end of the interest-only mortgage term.

If you achieved an average annual return of 7% then in 25 years, you would have an account worth: £170,050.25.

You can do your own calculations using our online calculators:

>>> Compare Repayment & Interest Only Mortgage Monthly Payments
>>> Stocks & Shares ISA Compound Growth Calculator

N.B. the above example does not constitute financial advice and is for illustration purposes only.  Investments can go down as well as up.  We recommend you speak with an independent mortgage adviser or an IFA to work out the best plan for your objectives and circumstances.

Pros

• ISAs offer flexibility of payment amount and regularity and money can be withdrawn at any time (sometimes with a notice period)
• All growth (up to ISA limits) is tax free
• Great variety in saving and investment vehicles (e.g. stocks and shares, deposit based savings)
• You can tap into the power of compound growth

Cons

• Investments can go down as well as up so there is no guarantee that the amount at the end of the mortgage term will be paid off fully
• If using a Cash ISA, interest rates can fluctuate so do not offer consistent returns
• Requires self-discipline to maintain the required regular monthly payments
• The government can change the law regarding ISAs

Pensions

A pension may be used in a similar way to an ISA to pay off all or part of the outstanding capital at the end of an interest-only mortgage term.  The objective is to pay a regular amount into a pension each month (e.g. the difference in monthly payments between a repayment and interest-only mortgage).  The monthly amount that is paid into a pension is then 'grossed up' by the government at the contributor's current tax relief rate.  Currently 25% of these contributions can be withdrawn from the pension as a tax-free lump sum on retirement.  It is this tax free lump sum that is used to pay off all or part of the balance owed on the interest-only mortgage.

From a tax persepctive, the main difference between a pension and an ISA is that pensions offer tax relief on the way in (contributions) and ISAs offer tax relief on the way out (withdrawals).  To learn more about how this works, please use the links below:

>>> How ISAs work
>>> How pensions work

Pros

• Pensions offer flexibility of contributions and regularity
• Contributions are increased by the government at the tax relief rate of the contributor (usually 20% or 40%)
• Great variety in saving and investment vehicles (e.g. stocks and shares, deposits, bonds, property etc.)
• You can tap into the power of compound growth

Cons

• Investments can go down as well as up so there is no guarantee that the amount at the end of the mortgage term will be paid off fully
• Requires self-discipline to maintain the required regular monthly payments, especially if a personal pension (e.g. SIPP) is used
• Money invested through a pension cannot be withdrawn until retirement
• The government can change the law regarding pensions

Sale of Property

Nowadays, very few lenders will accept the sale of the borrowers main residential property as a repayment method at the end of an interest-only mortgage term.  The reason for this is that the property's value may not increase in value enough to allow the borrower to pay off the mortgage, sell and downsize and buy a smaller, less valuable property.

The situation is different with buy-to-let mortgages.  As the property that is mortgaged is not the borrowers main place of residence, a lender is much less strict about repayment vehicles and in the majority of cases, will not need to see a repayment vehicle.  Even if the property's value increases only slightly over a 25 year term for example, the borrower can sell the property to repay the amount owing or even carry on paying a mortgage if it makes financial sense.

Pros

• Flexibility
• Good for buy-to-let mortgages as the interest-only mortgages mean lower monthly payment thus increasing the yield on buy-to-let investment property
• Can be particularly good if property is sold in a strong market

Cons

• There is no guarantee the value of the property will have risen enough by the end of the mortgage term to cover the outstanding mortgage balance
• The borrower may not be able to take out another mortgage at the end of the interest-only mortgage term (depending on their age and other lending criteria)
• The borrower may still owe the lender a significant amount of money as they approach or enter retirement age
• You probably won't have much freedom when the property is sold which can be negative if you need to sell in a weak market

Sale of Assets

Assets other than ISAs and pensions can be used to pay off mortgage debt.  Such assets can include business assets (including a business itself), company shares, other property, collectables, art or other items of value.

From a financial perspective, usually the best type of asset that is sold to pay off mortgage debt is one that is not producing an income, or one which is producing a low income.  For example, collectable motor cars, art or even land can have a lot of inherent value, but are probably producing very little income, if any.

Pros

• Flexibility - you may have choice over which assets you sell
• Otherwise unproductive assets can be used to pay off mortgage liabilities and therefore reduce outgoing household expenditure
• You can benefit even more if the market for a particular type of asset is strong when you sell it

Cons

• There is no guarantee that the sale of asset(s) will be enough to pay off a remaining mortgage liability
• If the market for a particular asset is weak at the time of sale, you may not realise as much money as hoped for
• The benefits of the sale may be liable for capital gains tax (CGT)

Endowments

Endowments can be used as a savings vehicle to provide a lump sum to fund a specific event in the future or more commonly, used for endowment mortgages to pay off interest only mortgage at maturity or earlier death.

When they first became popular, in the early 1980's, inflation was strong, interest rates were high and tax relief was available on premiums. In the 1990s, the projections could have been based upon a 7.5% mid-range growth rate. The assumed growth rates were even higher in the early 1980s.  The sums worked in favour of endowment mortgages - they looked like great ways to repay mortgages at the end of the term (typically 10 - 25 years).

However, tax relief on endowment premiums vanished years ago and inflation and interest rates have fallen hitting investment growth. Many people are finding that their endowments won't produce enough to repay their loans after 25 years, let alone produce the hoped for surplus.  This is why they are rarely sold nowadays.

>>> Endowment mis-selling claims
>>> Ways to make up an endowment shortfall
>>> How to sell an endowment policy
>>> Other options

Pros

• Endowments contain an element of life insurance which means that your mortgage will be paid off if you die before the end of the term
• If an endowment performs well, you may end up with a cash bonus in addition to the capital part of your mortgage being paid off (though has been been proven to be quite rare)

Cons

• If you stop paying an endowment early that has a terminal bonus, you are likely to lose this and in some endowments, this can account up to around half of the value of the endowment
• There is no guarantee that the value of your endowment at maturity will be enough to pay off the outstanding capital on your mortgage.  This has been the case with the majority of endowments
• Endowments are inflexible in that the money that has been paid in to them cannot be easily transfered into another saving or investment vehicle

Inheritance

The most common type of inheritance that people rely on to pay off an outstanding mortgage is inheritance when parents or other close family members die.  The obvious problem with this is that you would be relying for events to happen that are out of your control i.e. death to happen within a certain frame of time and that you are and would remain on someone's will as a beneficiary.

This is the least recommended of all the options and inheritance should be seen as a bonus, not relied on to pay off debts.

Conclusion

It is important to be aware that by taking on an interest-only mortgage and using a saving / investment vehicle to pay off the capital part of the mortgage at the end of the term is always going to contain an element of risk.  In other words, there is no guarantee that the saving / investment vehicle you use will have anough value to pay off your debt.

Very few lenders are offering interest-only mortgages on residential purchases and with interest rates so low, this is probably a wise move.

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Your home may be repossessed if you do not keep up repayments on your mortgage.