Is getting an Interest only mortgage a bad idea? An interest only mortgage does want it says on the tin, you are not repaying the money you’ve borrowed, simply paying for the privilege of doing so.
Its’s common for a residential mortgage to be taken over a long term say 20 to 25 years so it’s fraught with danger not to have a firm repayment strategy in place.
May I start but saying I’m a professional Mortgage Broker and NOT an investment expert, and suitable advice in this regard should be sort from an Independent Financial Adviser. And, I pen this article from my perspective at a time when we are in lock-down due to COVID-19 and ten years ago in a recession. Interspersed we have seen new life, low returns on savings, introduction of university charging and many relationships would have flourished or ended in divorce. The fact is disposable income fluctuates and often needs to be propped up by the generation before.
Endowments
In the 1980s and 1990s interest only mortgages were the norm supported by endowments. The view was the investment element would outperform the amount allocated to pay down the debt under a repayment mortgage. Mortgage Lenders liked the concept as the money was tied into the plan until maturity and they would register an interest in the policy, called “policy assignment”, so that it was cleared earmarked to repay the mortgage. It was widely thought by the Life Assurance Agents that not only would the mortgage be repaid but this would create a surplus on maturity to return to their clients. Unfortunately, many bombed leaving a shortfall.
So what happens in this instance? Well the Mortgage Lenders will look for you to make up the balance or even force sale of the property, which could in fact be your home! So this is serious stuff.
Pensions
Like endowments these are normally linked to investment performance. Their use for mortgages is normally limited to the “tax free” element of the pension pot that can be taken on maturity, which is typically 25%. When drawn this portion is to be used to pay off the mortgage debt. For example, the pension is worth £400,000 in total. £100,000 is taken and used to pay off the mortgage, with the residual £300,000 used to provide a regular income until death.
Again, Mortgage Lenders (depending in your age and mortgage term) used to be conformable with the concept as the pension could not be accessed until at least the age 55 years.
The rules are quite different now. It is common for the Mortgage Lender to want to see annual statements and illustrative projections for the pension maturity amount. Typically, they will only take 15% of the pension pot as the repayment vehicle, as to leave themselves a buffer. Also they might limit the offering to borrowers that have large annual salaries in excess of £50,000 to £100,000.
Even the platinum-coated final salary pension packages are under scrutiny right now as long term job and company stability are again called into question in the pandemic. With just 60% taken of an established pot a typical benchmark.
Sale of property
Downsizing your residential home is probably the most common strategy I encounter. The devil in the detail is vital here. For instance, selling up your town house to move to the coast is the obvious one. However, moving from London to an affluent area like Bournemouth is unlikely to free up a surplus to clear a mortgage. So equity is key. In fact, the Mortgage Lender is almost certainly going to look for £150,000 to £250,000 equity right now at the point of underwriting rather than what it may or may not be worth in the future. A minimum earned income level is also likely to be a pre-requisite.
Sale of buy-to-lets makes greater sense to a Mortgage Lender but most avoid the sale of commercial buildings as they do not have the skill set or inclination to evaluate them.
Stocks and Shares
This is probably the messiest in terms of Mortgage Lender acceptance. They can be fragmented across direct stock exchange listings, investment bonds, open-ended investment companies, units, SIPPs, ISAs etc. The health crisis has shown their volatility and even with regular IFA reviews in place the Mortgage Lender will take some convincing, and they are almost certainty going to need the investment to be under the watch of the UK regulators. Perhaps staggered bond maturity dates to pay off chunks of the mortgage at different times might smooth market blips?
Future income
Using projected future income and commissions to pay down the debt is another way to fund an interest only mortgage. COVID-19 though has decimated whole industries and many guarantees that were in place before seem increasingly unlikely to be maintained at the same level at least in the short term. So this seems very risky strategy to me.
Conclusion
| Pros of interest only mortgages | Cons of interest only mortgages |
|---|---|
| The investment could outperform the amount you pay on a repayment of a mortgage. | Greater uncertainty that debt will be paid at the term end. |
| Savings pot can be transferred to a new home so may suit applicants that plan to move regularly as a repayment mortgage is front loaded with allocation to interest rather than capital repayment. | Your home could be at risk. |
| Flexible you are only committed to paying the interest throughout the term so your monthly disposal income may be greater. | Your investment strategy could be disrupted by a life-changing event. |
| Affordability calculation might be beneficial with some specialists lenders ( but a lot of rules around this) | Investment returns subject to market conditions. Timing on value at maturity is particularly critical as the Mortgage Lender will call in their debt at a set time i.e. the end of the term. |
In summary
To return the question posed is “interest only” on a residential property a good idea, as supported above – it rarely is. It normally only ever suits applicants who are looking to move in a short space of time or high net worth applicants with defined lumps of money down the track. In fact when I was young I took irresponsibly take out an “interest only” mortgage once and regretted it. The primary objective must be to pay down the debt in a structured way and as soon as possible.
If you are risk adverse you can see the pitfalls and should probably stay away from interest only mortgages and plumb for capital repayment for your home.
If however, you are more of a risk taker then perhaps a mixture of the above “interest only” strategies would be the best way forwards. With perhaps with an emphasis on using the overpay facility of the mortgage product (if available) to pay down the debt quicker or offsetting a savings account.
I have also recently written about Repayment Mortgage so it’s worth reading so you get get the full predict around your options.
Whatever you decide Interest only or Repayment Mortgage you should seek professional advice before committing yourself to this long term debt.
Niche Advice Offers Interest Only and Repayment Mortgages so if you do need some advice do get in touch.
