Interest only mortgages, what’s the point?

I’m going to walk through my thoughts on what an interest only mortgage is, the advantages and pitfalls of them, and how they can be used to potentially pay off your mortgage in just over two thirds of the time.

If you can’t be bothered to have a read, then I made this video covering the same topic.

Many bloggers and YouTubers will tell you that the best way to be mortgage free in the quickest amount of time is to overpay your mortgage each month, in order to pull down the balance, and ultimately the term of your mortgage.

Now I’m going to suggest another strategy which may seem counter-intuitive, and some may have heard of but some might not have. That’s to pay down as little of the debt as possible, per month on an interest-only mortgage. Then use how much you can afford on a repayment mortgage to invest in the stock market. Now hear me out on this one, as I’m about to explain why this could work for you.

How it all works

Before I go into the details of the interest only mortgage and how it could save you money, it’s worth having an understanding of what an interest only mortgage is.

This type of mortgage is one where, as the name suggests, you only pay off the interest on the mortgage and not the capital. So if you bought a house using an interest only mortgage, at the end of the term of the mortgage, you would have only paid off the interest and the remaining capital balance will still exist.

Let’s say you want to buy a property worth £200,000 and have a deposit of £30,000. So you take out an interest-only mortgage of £170,000 at 2%, for a 25 year term. This means your monthly payments are £284 a total of £85,065 interest. Now I can already imagine the infuriated screams, of “but you won’t own your house with an interest only mortgage, you’ll still owe £170,000 at the end of the mortgage!”.

Yes, I know! So let’s pivot this thinking and think about how it could be used to save money and pay off a mortgage early. Imagine this same property is bought on a repayment mortgage at the same 2% and 25 year term. Your monthly payments are now £721. If you can afford to pay this larger monthly payment, it could be more beneficial to invest elsewhere.

You choose the interest only mortgage and decide to invest the difference between the two monthly payments, so £437 per month, in a cheap index fund which has a return rate of 6%. Under these nominal rates, you would reach that £170,000 mark in the index fund, at 18 years and 2 months, a full 6 years and 10 months earlier (roughly 2/3rds of the time of the original repayment mortgage).

And that’s it! you can pay off your mortgage early using this method.

The hitch

But actually, that’s not just it, because there are some inherent risks to this strategy. When you invest in the stock market, you have the ability for the value of a fund to go up and down, even if in the long run it goes up.

So you might find you’ve come to the end of the mortgage and your fund value has dropped due to a recession. You still have to pay the mortgage, so that loss has to be made up somewhere.

It also relies on interest only mortgage interest rates being low for the lifetime of the mortgage and stock market returns being higher. If this changes for an extended period of time, you might lose out in the long run.

Not only that, it relies on you sticking to this strategy yourself. If you were on a repayment mortgage and you decided to stop paying that £437 difference per month, the bank would repossess your house. But if you stopped paying into your index fund, there are no repercussions until the end of the mortgage. So it relies on you having the financial fortitude to stick with this long term goal and manage your own investment fund.

Endowment mortgages

To show how these risks can play out, it’s worth looking to the past to see how they already have played out. In the 1980s products by the name of endowment mortgages were quite popular. These were where you had an agreement with the bank for an interest only mortgage and you had a separate agreement with an insurance company. The strategy taken was then almost exactly the same. The insurer used your money to put into a fund in the stock market. Then at the end of each year, or sometimes at the end of the term of the mortgage, they would pay off the capital of your mortgage.

So what went wrong? When the policies were taken out inflation was high enough that there were high returns on these insurance policies of between 7 and 12 percent. Then when inflation dropped, this pushed the returns to as low as 4%. This meant that insurers could not provide their customers with enough to pay off their capital.

This means it is extra important to understand the risks involved if using this to pay off your own house.

Despite this however, you will still find that many large property investors use this strategy today. Sometimes this is in conjunction with rising property prices in certain areas and refurbishment, as means of extracting the highest return on investment. The risks involved and how they are used differ slightly, and is probably something to go into in another post.

So to summarise, this strategy isn’t for everyone. In fact, I would actually argue that for most people it’s a risky move and should stick with a repayment mortgage. But if you think you have the ability to achieve gains that outpace the interest on your mortgage and you’re able to put aside the emotional attachment to your debts, you might be able to use this as a means of paying off your mortgage significantly early.

Thanks for reading or watching, whichever option you chose and feel free to peruse through my other blog posts and YouTube videos as you wish.

2 thoughts on “Interest only mortgages, what’s the point?

  1. Good post but a few suggestions:
    No idea where you get a 25 year fix for 2% with a 15% deposit – interest only to boot.
    Your sums depend on the markets beating the mortgage costs – that’s ok but why no mention of using your 25% tax free lump sum to pay off the mortgage from your pension. Assuming tax relief going in and 25% tax free coming out makes a massive massive difference. Alternatively LISA makes a compelling alternative depending on your circumstances.

    1. I do recall when I bought my house about 5 years ago I was looking and found some that were close to these numbers.
      You can certainly get the rates that low these days, but you’re right that LTV is practically impossible, especially with most high LTVs having been taken off the shelves.

      You’re absolutely right, the assumption in my head was in an S&S ISA, but coming from a LISA or pension would benefit even more from incentives.

      There is a bit less flexibility with both those options, but definitely worth it if they are open to you.

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