Save now, pay later? In times of mounting personal debt, it is made easier all the time for us to put off till tomorrow what we dont feel like shouldering the burden of today. For the first-time buyer, interest-only mortgages are appealing as the cheapest way to get on the first rung of the housing ladder. But is this a risky tactic, and would they be better off biting the bullet and paying more at the start of their mortgage term?
How they work
An interest-only mortgage allows you to pay only the interest charged on your loan, but the capital itself is not repaid until the end of the mortgage term. This means that monthly payments are lower, but you still have to find a lump sum to repay the debt at the end of the term, although no mortgage lenders check that you do so. You can do this by putting money away in an investment vehicle such as an ISA, a pension or an endowment.
Alternatively, any profit made from the proceeds of the property sale can go toward repaying the debt, or if you are certain that a lump sum (say in the form of an inheritance) will come your way, you could use that.
A repayment mortgage, on the other hand, allows you to pay off both the interest building up on your loan and the capital the price of your property throughout the mortgage term, so you are debt-free by the end. The ratio of interest to capital varies throughout the term. In the early years, you pay much more interest, whereas later in the term a greater portion of your monthly payment goes towards repaying the capital. One reason for this is that you owe more at the beginning of your loan, incurring more interest, but as you start to repay the capital, the interest decreases on a sliding scale
How to choose
Ideally, a repayment mortgage is the better route, as you are repaying the debt and it also allows you to remortgage from a stronger position, says Paul Hearnden, managing director of broker MyMortgageDirect.
In other words, the more you build up some equity in your property, the more flexibility and bargaining power youll have with lenders when it comes to switching to a new lower rate or even arranging a payment holiday. Youre also more protected if property prices fall.
Whether you take out a repayment or interest-only mortgage, you should be able to afford to pay off both the capital and the interest on your loan. A repayment mortgage, despite the slightly higher payments, is the solid and secure guarantee you will pay off your debt.
Trouble ahead?
The percentage of people opting for repayment mortgages has actually increased from 18 per cent in 1991 to a staggering 75 per cent in 2004, according to data from the Council of Mortgage Lenders (CML).
Hearnden estimates that about 50 per cent of his clients taking out interest-only loans have no repayment vehicle at all. He says: Its not necessarily people overstretching themselves, but they are stretching themselves to the limit. Often its more a lifestyle choice than an affordability choice. Borrowers are still assuming that property prices will rise enough to repay the capital. This live today, pay tomorrow culture could be storing up a very big problem for years to come.
Payback
Paying your mortgage on an interest-only basis and setting up a repayment vehicle to back it can be an option for all borrowers, but you must be prepared to accept the risk involved. If your investment is linked to the stock market, theres a chance it might underperform and not only fail to cover your loan but leave you with a shortfall, as weve witnessed in the last few years with endowment policies.
However, if you have faith in your investment and are confident it will repay well, and if you are not risk-averse, an interest-only mortgage could work for you, says Elliot Nathan, product development manager at broker Charcol.
Up the creek without a paddle?
Taking on an interest-only mortgage without setting up a repayment vehicle is a risky option. There are some lenders, HSBC for example, that will only arrange an interest-only mortgage if the borrower already has an investment vehicle in place. Nationwide Building Society restricts the interest-only route to homeowners with a minimum of £150,000 equity in their property.
However, when you compare the monthly cost of a repayment mortgage against the cost of an interest-only mortgage plus contributions to an investment vehicle, theres little difference. Interest-only mortgage repayments are only noticeably cheaper without a repayment vehicle. Nathan suggests that first-time buyers for whom the cost of repayments can be crucial, especially in the first couple of years after moving in may find interest-only mortgages attractive.
As you pay more interest in the first few years of a repayment mortgage anyway, he argues, its much the same format as opting for an interest-only loan and then changing to a repayment mortgage a few years down the line. Indeed, many lenders offer this option HSBC even has a specific product, Home Start, which does just that.
If you do take out an interest-only mortgage, aiming simply to remortgage to a repayment vehicle two or three years later, you are fully within your rights to do so. But remember that you will not own any more of the property three years on than you did at the start. This will mean you will have less equity and so deposit to take with you when you choose to sell, which could be seen as the financial equivalent of being kept down a year or three years at school.
However, with current affordability problems for many (particularly first-time) buyers, this issue is fast becoming a luxury few can afford to worry about.
CASE STUDY:
IT training consultant Stuart Dray (30) from Worthing stepped on to the property ladder for the first time in summer 2004. After taking advice from his mortgage broker L&C, he opted for a two-year 4.59 per cent fixed rate with Alliance & Leicester on an interest-only basis. He could have afforded the monthly payments on a repayment basis, but he wanted to be able to buy furniture for his flat and a car without being too pushed.
I had a bed, but no other furniture or fridge, et cetera, he says, so the money that would have gone on a repayment mortgage has gone to set up my home as I want it.
He already had a £3,000 ISA in place and an increase in his salary over the last year has meant he has been able to add a small amount to it, as well as save an additional £3,000. If Id been on a repayment mortgage, that might all have been eaten up.
As his £2,000 car loan will finish at the same time as the two-year fixed rate is up, he will be in a good position to switch to a repayment mortgage then. I dont intend to keep my mortgage on an interest-only basis for long, he emphasises. Its definitely a temporary thing.
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