Looking at getting a mortgage in the UK or the UAE? Here Holborn Assets reviews key strategies to make an interest-only mortgage work for you.
When you take out a type of mortgage, you may choose one of the two Biggies: full-repayment, or interest-only. Full-repayment means you borrow a capital sum to cover the purchase of a house and pay back the capital sum plus interest. Interest-only means you only pay back the interest on the mortgage.
Before we look at some canny ways to deal with an interest-only mortgage, a quick word on the alternative: conventional full-repayment mortgages:
Monthly spend on a full-repayment mortgage can be theoretically as regular as clockwork. But more than likely,
the amount will vary greatly, year-on-year, as a result of:
- Interest rates rising and falling.
- Switching from a floating rate to a fixed rate, or vice versa.
- Snapping up a better repayment rate offered by a different lender (i.e., ‘refinancing’, or ‘recasting’ your mortgage).
Dig deep for decades, ride the wave of rates and deals, and you can raise a glass on that final monthly repayment for that house being ALL yours!
Interest-only mortgages work very differently, however – arguably requiring an entirely different mindset.
The structure of interest-only mortgages is very simple: instead of a monthly payment that comprises both a little bit of the capital (i.e., the amount you’ve borrowed) and the interest, you pay only the interest. This means that you still owe the lender the capital amount borrowed at the end of the mortgage term; in other words, you never end up owning the property.
This financial vehicle suits Buy-To-Let (BTL) buyers very well: it allows them to rent a property without the inconvenience of ever fully owning it!
If you’re not looking at BTL, why go for an interest-only mortgage then? Well, it may suit your existing financial picture; interest-only mortgages were created so that lenders can add to their long-term income mix: smaller monthly payments (compared to full-repayment customers) in lieu of that big payoff at the end.
As the payment schedule proceeds, a key strategy is to independently build up a lump sum to pay off the capital in one go at the end. So it’s important to look at your approach to your finances right now.
Firstly, are you a solid saver already? How much of your income is put aside each month for a rainy day? If none, or very little, then it’s worth getting into this habit first before you embark on any mortgage type. Transferring earnings on a regular basis to the most liquid products – savings accounts, and Independent Savings Accounts (ISAs) would be a start, particularly since ISAs give you tax-friendly interest.
If you’ve got these things in place already, it’s worth looking into regular savings vehicles that allow your contributions to flow into fund units to generate a return. This is not just to support your own extra commitment to saving: a mortgage lender will need to have some idea as to how you’re going to pay off that lump sum. So having these savings vehicles in place will allow you to show you’re committed from the outset.
What kind of savings vehicles do you need?
The Money Advice Service has a useful list, which includes savings accounts and regular cash ISAs, though points out that some lenders don’t count these contributions as part of your mortgage payback. The rest of the list comprises stocks and shares ISAs, pensions, investment bonds, shares, unit trusts, regular savings plans like endowment policies, and property and other assets.
Don’t I need my savings to fund my retirement rather than my mortgage?
Indeed – this blog has recently covered not only how more of retirement funding will be in the hand of the individual, but how personal pensions are being used as a result of the recent increase in their drawdown flexibility.
And this is the crux of the matter. If you want to be a saver with mid- and long-term retirement goals, AND you have an ambition to build up to that house lump sum, you will need to be dedicated to researching the market, finding the right product for you (a financial adviser is very well-placed to guide you through), and keep regular tabs and how it is performing.
In other words, the money saved from lower monthly amounts compared to a full-repayment needs to work as hard as possible. The underlying investments need regular reviews, and usually a variety of different products (eg. personal pensions as well as ISAs) as per the list above.
With your adviser, it will be important to deduce if a single product (such as a stakeholder pension) can be used to receive both mortgage-payment contributions and retirement contributions, with both managed from the same place, or whether separate products for these very different purposes (i.e., the lump sum required at the end, and the growth target you’re comfortable with to achieve it) is more suitable.
What kind of flexibility exists with interest-only mortgages?
That depends on the lender. Some allow monthly overpayments. Thus, instead of paying the minimum amount each month, you voluntarily pay more, and this extra essentially reduces the loan you originally took out. So, if you were to make regular overpayments on an interest-only mortgage for that that £200,000 loan mentioned above, for argument’s sake, it may reduce to £150,000 by the end of the loan.
This may be a valuable option if you have concerns that your regular savings vehicle won’t reach the goal amount by the month and year it’s due. Obviously you will need to check that you can make overpayments without penalty, otherwise you’ll be doing yourself a disservice.
Also, bear in mind that interest-only loans can be for far shorter periods than full-repayment.
It’s also important to tie in the choice for an interest-only mortgage (whether regular payments or overpayments) with the overall picture of your finances.
For example, if you have liabilities with a higher interest rate than your mortgage (such as a credit card or advance loan) the smart move would be to pay off these debts first. On the other hand, if your ISA or savings account pays a far lower interest than that which your mortgage is charging you, seriously consider look into these overpayments.
MoneySavingExpert has an ace calculator to let you run the mortgage numbers for yourself. And, once you’ve had a look yourself, be sure to talk to a financial adviser who can put your unique figures into market context – and perhaps steer you to a canny deal!