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Why I’m not scared of my interest-only mortgage

15

Wealth warning: Interest-only mortgages are like power tools – useful in the right hands but capable of chopping them off. If you’re not sure you’ll stay interested in your finances for three decades, avoid! Get a repayment mortgage and keep life simple.

I have an interest-only mortgage. This confession causes some friends – and Monevator readers – to gasp.

Am I not a financial blogger? Don’t I know interest-only mortgages are risky? Weren’t they associated with the financial crisis?

“Are you nuts?”

I have my moments, but I’m mostly a responsible sort. And I believe interest-only mortgages are not as toxic as their off-ish odour suggests. In a couple of ways they’re arguably less risky than repayment mortgages.

Interest-only mortgages do have one big downside. We’ll get to that.

But they also have a couple of advantages.

What is an interest-only mortgage?

A quick refresher, and then on to the concerns.

  • With an interest-only mortgage, your monthly debits to your bank only pay the interest due on your loan. You don’t repay any capital – and you needn’t until the end of the mortgage term. At that point the entire debt is due.
  • This contrasts with a repayment mortgage, where you make capital repayments as well as interest payments each month. At the end of a repayment mortgage term – typically 25 years – it’s all paid off.

One obvious advantage of an interest-only mortgage is your monthly payments are lower, because you’re only paying interest, rather than capital and interest.

This may be appealing when house prices are high and interest rates are low.

Suppose you took out a £400,000 mortgage over 25 years at a ten-year fixed rate of 2.5%:

  • Monthly payments with an interest-only mortgage: £834
  • Monthly payments with a repayment mortgage: £1,795

Quite a difference! You’ve nearly £1,000 left in your pocket each month with the interest-only option.

Low rates make interest-only mortgages look like a winner. Here’s the same scenario with 1990s-style 12% interest rates:

  • Monthly payments, interest-only: £3,999
  • Monthly payments, repayment mortgage: £4,212

With very high interest rates, there’s is little difference between monthly interest-only or repayment payments. Either way most of your initial payments go on interest.

Today’s very low rate environment makes the interest-only option appear attractive when you’re only looking at monthly payments. Because rates are low, there’s little interest to be paid.1

Screamingly important: It’s not all about monthly payments!

These comparisons tell us about monthly payments – but not about the big picture of buying your home outright.

That’s because the interest-only mortgage is not being paid off.

In my example, with the interest-only mortgage there will be a £400,000 debt due at the end of the 25 years.

This gaping hole will need to be filled, either by selling your property to repay the mortgage – not usually a permitted as a plan for residential owners – or by using capital from elsewhere. (Aha!)

In contrast, the repayment mortgage will be paid off in full after 25 years. And long before then the debt will have dwindled significantly.

What’s more, the total amount you pay to own your home will be higher with an interest-only mortgage.

  • As you pay down capital with your repayment mortgage, interest is charged on a shrinking outstanding balance, which reduces the future interest due.
  • With an interest-only mortgage you pay interest on the full debt for the life of the mortgage.

I’ll get back to this in a moment.

The repayment mortgage as a piggy bank

We might think of a repayment mortgage as like a ‘forced’ savings account.

True, it’s a strange sort of savings account, because it starts with a massively negative balance – of minus £400,000 in my example – and eventually you ‘save’ back up to breakeven.

But it works the same way.

Every £1 you put into repaying off the outstanding capital increases your net worth by £1, compared to if you’d spent that £1 on sweets or beer, because you’ve now paid off £1 of debt.

If you started with a negative balance of £400,000, you now only owe minus £399,999.

You’re richer!

A repayment mortgage is often even better than a normal savings account, because you don’t pay tax on your ‘interest equivalent’ when reducing your mortgage, but you might pay tax on interest on cash savings. Depending on your total income and tax bracket2, this means repaying debt may deliver a higher return than earning interest on savings. (It’s all been made a bit more complicated by the introduction of the savings allowance though. Check out this primer from Martin Lewis if you want to do the sums.)

Of course the downside of this ‘mortgage pseudo-savings account’ is your home could be repossessed if you fail to make your payments. That’s several dozen shades darker than the worst that can happen with a real savings account.

Five perceived problems with interest-only mortgages

Let’s crack on! Let’s look at some arguments people make against interest-only mortgages, and why they aren’t necessarily a concern – and certainly don’t amount to a toxic product – in the right circumstances.

1. An interest-only mortgage is more expensive

This is one of the best arguments against using an interest-only mortgage – or perhaps I should say against misusing it.

Going back to the £400,000 mortgage charged at 2.5% for 25 years:

  • The repayment mortgage costs a total of £538,4093
  • The interest-only mortgage costs a total of £650,1134

The difference is in the interest bill. It is £111,704 higher with the interest-only mortgage. As I wrote earlier, that’s because you’re charged interest on the full £400,000 for the life of the interest-only mortgage.

Now you might be thinking you’ve spotted a gaping hole here in the logic of using an interest-only mortgage.

We’re trying to get richer around, right? Not poorer.

But as mathematician Carl Jacobi’s maxim states5“Invert, always invert.”

With the interest-only mortgage in this example, you are effectively paying £111,704 in additional interest6 to rent £400,000 from the bank for 25 years.

After that, money that would have gone into repaying the mortgage can instead go into investments that will probably deliver a higher return overall.

Not a higher return than house price growth – that’s irrelevant here, see point #3 below – but a higher return than the 2.5% interest rate your bank is charging, adjusted for your personal tax situation.

That basically means global equities – shielded from taxes in an ISA or SIPP – which might be expected to deliver annual returns of around 7-8% a year, depending on who you ask and what period they look at. (Remember we can use nominal returns here, because your mortgage interest rate hurdle is also nominal. In real terms the value of your £400,000 debt is being shrunk over time, too.)

If you use an interest-only mortgage and invest, you’re effectively gearing up your portfolio with the mortgage debt. Every pound of debt that’s not repaid is effectively invested into your portfolio instead, for 1-25 years.

If all goes well, you’ll end up richer. After 25 years you’ll pay off your mortgage balance and the excess (we hope) is yours to keep.

Of course it’s not a slam dunk. Investing in equities – even with a lengthy 25-year time horizon – is much riskier than repaying a mortgage, which delivers a known return. There are no guarantees.

Also tax looms large. Compare an after-tax gain on equities with an effectively juiced-up after-tax return from paying down debt, and the potential differential shrinks.

For me this means that while I have headroom in my annual ISA and SIPP allowances, I’m planning to effectively run a larger, leveraged, tax-sheltered investment portfolio, rather than pay down my interest-only mortgage – at least for the next 10-15 years.

If I have spare cash after that (after an emergency fund and so on) I’ll throw it at the mortgage.

This is definitely a personal decision, and I guarantee people will turn up in the comments saying it’s too risky and you should just pay down your mortgage debt.

Notice though that these same people will often be paying into a pension while carrying a repayment mortgage – in some ways a similar proposition, though not one I’d personally argue against for a minute – or perhaps they had a defined benefit pension and were never faced with such decisions. (Certainly anyone who says using an interest-only mortgage while they themselves have a repayment mortgage at the same time as they’re saving into an ISA, let alone a general un-sheltered investment account, is riffing on their cognitive dissonance!)

Remember too that plenty of people have taken out interest-only mortgages without any plans to repay the debt. This is mostly why interest-only mortgages have a stinky reputation. But that is the opposite of what I’m suggesting here! I’m doing this entirely to grow my wealth, a portion of which should one day be used to pay off my outstanding mortgage.

Also note that you have some optionality with the interest-only approach.

My interest-only mortgage T&Cs allow me to repay up to 20% of the outstanding debt off in any particular year.

If markets do much better than I expect at any point over the 25-year term, then I can switch from investing more to repaying the interest-only mortgage before the debt becomes due, or maybe even deploy lump sums liquidated from my ISAs against the mortgage (though it’s hard for me to conceive of doing that and losing some of my precious ISA wrapper…)

Ditto if interest rates rise, and it becomes more expensive to run the interest-only mortgage.

Here’s a couple more articles to read on the topic:

As so often, it’s make your own mind up stuff.

The Accumulator changed his mind in a similar-ish situation and decided to focus on reducing his mortgage debt rather than maximising his investing gains. No shame in that!

2. You’re not reducing the capital you’ll eventually owe

The second – also excellent – argument is that paying off, say, £400,000 is a massive slog for most of us, and you’d be best off starting early.

I agree that for many people this is wise advice.

However even with a repayment mortgage you might not be repaying much capital in the early years, depending on rates.

Sticking with my £400,000/2.5% example (and rounding for ease of reading) in the first year of a repayment mortgage you’d pay £9,860 in interest. You’d only pay off £11,666 of the outstanding capital.

So that’s roughly 45/55 interest to repayment.

The figures do get better over time. By year ten you’re repaying £14,610 a year in capital, with less than £7,000 going on interest. This is because your prior repayments have shrunk the debt that interest is due on.

But a big chunk of your early bills are actually going towards servicing interest, even with a repayment mortgage.

And it’s much worse when rates are ‘normal’.

At a more historically typical mortgage rate of 6%, you’d pay nearly £24,000 in interest in year one on that £400,000 loan, and merely £7,000 of the capital.

That doesn’t seem so much a repayment mortgages as a mostly-interest-mortgage!

Here’s an illustration of the interest/capital split under a 6% regime. Notice how long it takes for capital repayments to outweigh interest payments:

With a 6% interest rate, even a repayment mortgage is mostly paying interest early on.

Of course we don’t currently live in a 6% regime. You could argue that with today’s low rates it’s actually a great time to have a repayment mortgage and to slash your long-term debt, exactly because most of your payments are going on capital.

It’s a coherent argument.

My point is simply that both interest-only and repayment mortgages feature a lot of interest-paying, at least initially.

It’s just a bit disguised, because when a bank rents you money to buy a house, it all gets wrapped up in one monthly bill.

3. You’re not smoothing out your housing exposure

This argument is wrong thinking, but I’ve heard enough people say it that I suspect it’s pretty common.

The (faulty) logic goes:

With a repayment mortgage, you’re gradually increasing your exposure to property as you pay down your debt.

Often they will add something like:

“The stock market looks wobbly, so instead of investing I’m going to make some extra payments towards my mortgage in order to put more into the property market instead. You can’t go wrong with houses!”

I’ve even had a friend suggest to me that repaying his mortgage over time (including with over-payments) is like pound-cost averaging into the stock market.

But while this certainly results in good financial discipline, the theory itself is nonsense.

When you buy a property is when you get your ‘exposure’ to the housing market. Your exposure going forward is the property you bought. The cost of that asset is the price you paid when you bought it.

Everything else is financing.

Most of us take out a mortgage to buy our home. How we choose to pay that off – every month for the life of the mortgage or in one lump sum in 25 years, or something in-between – is about managing debt, not altering our property exposure.

If you make an extra £50,000 repayment towards your mortgage, you haven’t got £50,000 more exposure to the housing market. Your property exposure is still whatever your house is worth.

Rather, you’ve paid off some debt (/done some enforced saving!)

True, it’s debt that is bucketed against the specific asset of your home. But that’s it.

The way to pound-cost average into the residential property market is to buy multiple properties over time, or to invest in a loft extension or similar.7

4. What if you can’t make the interest payments – you won’t own your home?

People seem to believe using an interest-only mortgage is more precarious than a repayment mortgage. You often see this insinuated in articles.

There is a feeling that somebody living in a home financed with a mortgage where they’re not paying down debt each month is living on a limb.

But your financial situation is more than just your house and your debt.

It includes your cash savings, your investments, your pension, your monthly income, your liabilities, and more.

When I bought my flat with an interest-only mortgage, I put down a 25% deposit. Since then I’ve repaid almost no capital8.

In contrast, my friend P. bought a flat around the same time as me with a 20% deposit and a repayment mortgage. He will have since repaid a couple of percent of his mortgage.

I don’t see that he’s in a more secure position than me, on these bald facts alone.

  • Neither of us own our properties outright.
  • Both of us could be repossessed if we fail to make our mortgage payments.
  • He’s made bigger monthly payments to his bank. I’ve put a higher percentage of my net income into investments.

You could even argue that my interest-only mortgage is less risky, on a month-to-month basis. My monthly payments are lower, and so they would be easier to meet in a pinch. The rest of the time I can – and am – diverting the spare cash into building up my other savings and investments, not spending it.

This actually gives me more of an accessible ‘liquid’ buffer than he has.

With an interest-only mortgage you can also spread your assets more widely than someone who is putting everything into paying down their repayment mortgage ASAP.

Their assets may be very over-weighted towards one single residential property. More of yours will be in global shares and bonds (effectively financed by your mortgage…) in addition to property .

Of course, if you just use your lower interest-only payments to live beyond your means rather than building up your investments then it’s a different story. I’m not arguing for paying lower monthly bills and then moaning to the regulator in 25 years that you didn’t understand you had a debt to repay!

But blame the player in that case, not the game.

5. You don’t ‘really’ own your home, even if you do keep up the payments

My mum said this to me. She seems to believe she always owned her home because she was paying off her mortgage each month, whereas because I’m not she thinks I don’t own mine.

This is all hand-waving stuff.

Some people say the same about homes bought with repayment mortgages, too. They say the bank ‘really’ owns your house. That you’re just renting until you’ve paid off the mortgage. Until then you’re a tenant of the bank, which is the ‘true’ owner.

This is wrong, legally speaking.

When you buy a house you take legal ownership of that property9. It’s registered under your name at the Land Registry, and you have various rights and responsibilities that come with ownership.

If you happen to buy it with a mortgage, then you’ve also taken on commitments to the bank that lent you the money.

Because some people don’t repay their debts, banks want some security.

And… you’ve just bought a home… so hey, there’s a big lump of hard-to-move security sitting right there!

Invariably then, when a bank lends you money to buy a property, this loan is secured against that same property. That’s why the bank gets your property valued beforehand. (You didn’t think it was for your benefit, did you?)

There are all kinds of implications from using a mortgage like this, but not owning your home isn’t one of them.

Of course with an interest-only mortgage you do need to repay the debt eventually to stay in your home. Your 25 years of home ownership will come to an end if you have to sell your home to pay off your mortgage.

That’s 100% true.

But it’s not a reason to avoid an interest-only mortgage – it’s a reason to have a plan.

Outstaying your interest

There’s a vogue on this site at the moment to crunch numbers, but at 3,000 words I think this article is weighty enough.

Boiling it down, it’s a pretty simple concept…

Investment returns > extra interest-only mortgage costs = win

Investment returns < extra interest-only mortgage costs = loss

… maybe adjusting your investment returns by a risk factor to reflect the uncertainty of gaining them.

I’ll say it again, to try one last time to stop someone in the comments saying I said something else – for most people, a repayment mortgage is a simple, reliable way to buy a home. It will probably reduce your financial vulnerability over time. It should be the default choice.

But for those of us who like to juggle our finances for fun and profit, an interest-only mortgage is well worth considering.

  1. Then again, high rates usually come with high inflation, and that would be eroding the real value of your debt quicker. []
  2. And the interaction with your personal savings allowance. []
  3. Mortgage debt of £400,000 and interest of £138,409 []
  4. Mortgage debt of £400,000 and interest £250,113 []
  5. via Charlie Munger. []
  6. Of £250,113 in total interest. []
  7. Or to buy shares in one of the few listed companies that owns substantial amounts of residential property, such as Mountview Estates. []
  8. I made one small ad hoc payment to ensure it worked. []
  9. Well, assuming you own the freehold. It’s more complicated with a leasehold property, but let’s save that for another day. []

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