With finances becoming more and more stretched, it seems the obvious answer to try and cut back on your biggest outgoing, which for most of us is our mortgage. But is this possible? Let JSTFinancial guide you through the pros and cons of a very turbulent mortgage market.
The obvious choice is to go on ‘interest only’ for a short period of time. Switching to interest only, means you pay just the interest element of the mortgage whilst putting your capital repayments on hold. In the short term, it can reduce your monthly outgoings by a significant amount, but in the long run it will definitely cost you more.
Research by investment firm Liverpool Victoria has found that around 1.3million homeowners, worth around £75bn in interest-only mortgages could be in financial peril due to falling property prices. Many people take out an interest-only mortgage in the hope that they can use the increase in value of the property to pay off their debt further down the line. But with house prices plummeting to their 2005 levels, this approach could prove to be very costly, as there is just not the equity that people anticipate in their homes.
How does an interest only mortgage work?
If we look at the national average house price now around £160,000 as an example. There are two main mortgage options.
Option one
You take out a repayment mortgage (where the capital sum borrowed and interest are repaid simultaneously over the term) over 25 years at an interest rate of 6%, which seems to be what most of the main banks are currently offering. That means your monthly repayments are £1,030.88. All things being equal, you'll pay a grand total of £309,264 over the term.
Option two
You take out an interest-only mortgage for the first five years at the same rate of 6%. This time your monthly repayments will be lower at £800. So you'll be making a handsome saving of £230.88 each month. That sounds rather good. But does this it really make good sense?
Over the next five years you'll pay a total of £48,000 in monthly interest repayments, but you won't repay any of the capital you have borrowed, i.e. your £160,000 mortgage.
After five years you decide you need to start chipping away at your debt so you switch to a repayment mortgage for the remaining 20 years of the term. Of course, your payments increase significantly for two reasons. One: to make up for the fact that you haven't repaid any of the capital in the previous five years. And two: because you'll be repaying the capital from now on.
Your new repayments for the next 20 years will be a lot higher at £1,146.29 (assuming the same 6% rate throughout). This is no joke if your financial situation hasn't improved considerably since you first took out your mortgage. You'll now be paying more than £4,000 extra every single year just to clear the debt to your lender.
Over the next 20 years you pay a total of £275,109.60. But don't forget the £48,000 you have already paid in interest-only payments over the first five years. That means your grand total is £323,109.60. In other words, taking the interest-only route and switching to a repayment mortgage after five years will actually cost you an extra £13,845.60.*
This is why repaying your mortgage on an interest-only basis should really be your last resort as - in this example - it could cost you almost £14,000 more for the privilege. Of course lots of us switch to interest only mortgages in difficult economic conditions, as a quick fix short term solution. But ultimately that will have a similar effect to the example above.
So, before you think about skipping capital repayments for a while, it could be a more cost-effective solution to remortgage to a more competitive deal before resorting to the interest-only option. Let JSTFinancial.co.uk find the best deal for you, with the dramatic cuts to base rate last week; we may be able to find a cheaper loan than you think.
That said, you may find moving to interest-only is the only viable option for your circumstances right now. Especially, if the alternative is falling into arrears with you mortgage. If you really have no choice, try to switch back to a repayment basis as soon as you can. That way you'll limit the amount you rack up in extra interest. And remember you may be able to compensate for the interest-only period by overpaying your mortgage when your financial situation improves, which is always a good idea. Most mortgage lenders let you overpay by at least a minimum of 10% per year, which can reduce your payments significantly.
Interest-only versus repayment mortgages
Interest Repayment
Payments for first five years £800 £1,030.88
Payments for remaining 20 years £1,146.29 £1,030.88
Total paid over first five years £48,000 £61,852.80
Total paid over remaining 20 years £275,109.60 £247,411.20
Total amount paid over 25 years £323,109.60 £309,264
Extra paid by choosing interest-only option £13,845.60
*Source-uk.biz.yahoo.com November 2008