Are you better off with an interest-only or a repayment mortgage? Andy Stuart, Editor-in-chief of Your Mortgage magazine, offers advice for finding your way through the mortgage maze
There is one thing that will never change about a mortgage – eventually you will have to repay the loan.
You only get two choices when it comes to paying off your mortgage and, as with many things in life, one means playing it safe while the other means taking a risk.
Your first option is an interest-only mortgage. Every month the only responsibility you have is to meet the cost of the interest on your loan. This obviously means cheaper monthly payments. But you are then left with the rather large problem of how you are going to pay back the amount you originally borrowed.
The solution is to use the proceeds of a separate investment plan. For many years this meant taking out an endowment policy, but now you can also choose to invest in an ISA or even a pension plan to clear your mortgage. The idea is that you put money into your chosen investment vehicle every month. This should then grow at a rate that will enable you to pay off your mortgage debt at the end of the term, possibly leaving you with a tidy tax-free lump sum into the bargain, although there are no guarantees.
The alternative is to take out a repayment mortgage. Every month you make a payment that partly pays the interest on the amount you have borrowed and partly repays the outstanding loan. At the end of the term the mortgage is guaranteed to be repaid in full.
With an endowment policy, the provider calculates how much your investment will be worth assuming it grows at four, six or eight per cent for each year of the term of your mortgage. However, these are only projected figures and there is no guarantee your endowment will grow at a rate that will enable you to eventually pay off your mortgage debt.
In fact, there were many endowment policies sold during the late eighties and early nineties that have not performed as well as expected. Following the well-publicised misselling scandal, there are now thousands of borrowers who have been told that they must substantially increase their premiums or face the prospect of having an outstanding debt when their policy matures. This is a scenario that has not gone unnoticed by the next generation of homebuyers.
‘In the late eighties endowment policies were very popular because you were initially guaranteed a good return,’ says Mark Hemingway of Halifax. ‘Then these returns dropped, some people got their fingers burnt and, as a result the market has shifted back towards repayment mortgages. These now account for 95 per cent of our mortgage business.
‘People want more flexibility but they also want to see their debt reducing and have the certainty of knowing that the loan will be paid off. You don’t get that with an interest-only deal. We anticipate the majority of people will continue to choose repayment mortgages.’
Interest-only mortgages are no longer just linked to endowments. Today, you can also choose from an ISA or a pension to pay off your mortgage. But although they may be tax-efficient and offer good returns, there is a risk that you may not clear your debt.
Which option you choose depends on your circumstances and the type of person you are. If you enjoy taking a risk, then the prospect of the pot of gold at the end of the interest-only rainbow may be too much for you to resist. But if you crave security and certainty, look no further than a repayment mortgage.
Interest-only
Pros
· Potential to pay off your mortgage ahead of schedule and earn a tax-free lump sum
· Built-in life assurance
· Do not have to start a new loan if you move house
Cons
· There is no guarantee your loan will be repaid
· You may to have to increase your premiums to cover any shortfall
· If you have to cancel or sell your endowment policy early the potential return will be greatly affected
Repayment
Pros
· Your loan is guaranteed to be repaid by a set date in the future
· More flexibility. Many lenders will allow you to overpay, underpay, borrow back money or take a holiday without any charge
· Provides more security and is easier to understand.
Cons
· You have to organise your own life assurance – a must if you have dependants
· No possibility of a tax-free lump sum
· You have to start a new loan every time you move house.