Interest Only Mortgages - Are They a Good Idea?

Interest Only Mortgages - Are They a Good Idea? Many people opt for an interest only mortgage for one simple reason - it's the cheapest option.

You can't blame people for choosing the 'lowest' cost option, can you?

So how does an interest only mortgage work (I've had many clients call it an interest free mortgage - if only!), as against the other option of a capital repayment loan?

With an interest only mortgage, you only pay back the interest on the mortgage every month. So, for example, on a £150,000 mortgage you would cut annual payments by around £3,000 as opposed to the repayment option.

But of course this means that you are not paying off any of your debt - the capital. And at the end of the loan term you would still owe £150,000.

If you want to repay capital from day one of your loan, then you need to take out a repayment mortgage. This spreads the interest and repayment into one monthly payment, typically over 25 years. This then guarantees to pay off your debt.

So, lets look at costs.

For a £150k loan at say 6% over 25 years, the difference per month would be circa £222. So you could say that over the 25 years you have saved £66,000 - but at this point you have to pay back the lender the £150,000.

It is also true to say that over the term of the loan, the interest only route will mean you will actually pay more in interest.

Why?

Well, if you do not pay back any of the £150,000 capital debt, the lender will charge you interest on the entire loan for the entire term. Whereas with a repayment mortgage, you are trying to get rid of your debt from day one and you will therefore gradually chip away at it until it's all gone - meaning the debt gets smaller which affects the amount of interest you pay overall.

On this sort of example, the interest saved would be around the £80,000 mark.

So, ideally, we should all have a repayment mortgage.

Clearly, using the interest only route when you are struggling to cover costs as a new buyer is perfectly valid.

It is also worth mentioning that the following reasons could be part of an overall strategy that a doctor/dentist can use:

- maturing policies/pensions<br> - pay more later re promotion/private practice building<br> - using offset accounts and "parking" tax monies/spare cash<br> - downsize<br> - sell "buy to lets" in future<br> - inheritance

All of these are perfectly valid, but do not put your head in the sand, plan, and plan well.

The Financial Tips Bottom Line:

As you can see, the interest only route has its merits, however the negatives outweigh the positives. If you have recently purchased a property with an interest only loan, make a point of reviewing it (perhaps when your deal comes to an end) and switch to a repayment mortgage when the timing is right.

About the Author:

Ray Prince is an Independent Financial Planner with Rutherford Wilkinson plc, and helps UK Resident Doctors and Dentists get the best deals on mortgages, protection and investments, as well as helping them achieve their financial objectives. Just visit www.medicaldentalfs.com to get your free retirement planning guide. Rutherford Wilkinson plc is authorised and regulated by the Financial Services Authority.