Interest only mortages and overpaying?

Lisdeleau

We are about to buy our first house and an IFA has suggested that we go for an interest only mortgage but overpay (the product he is suggesting allows 10% overpayments). His reasoning is that for the first few years of a repayment mortgage you're only paying off the interest anyway. This sounded a bit odd to me so I called another IFA who advised against this - who should I believe?!

_Andy_

Sounds pretty shoddy advice to be honest.

dunstonh

The second one.

Even if you set it to interest only and overpay (by the same amount that you would pay on a repayment mortgage) the end result is the same.

Better to go on repayment mortgage and if you have surplus funds, either overpay or increase your emergency fund/savings.

Cannon_Fodder

Whether by Repayments or IO plus 'overpaying', the effect is the same mathematically. You could be on Repayment AND overpay, if you wished.

Use an amortization calculator, such as http://www.abacusfinance.co.uk/repayment-calculator.php to see the effect of repayments;

Example; with £100k at 5% for 300 months (25 years) gives...

Monthly Payment = £584.59
Month Balance Principal Interest Paid Total Int.
1 £99,832 £168 £417 £585 £417
2 £99,663 £169 £416 £1,169 £833
3 £99,494 £169 £415 £1,754 £1,248
4 £99,324 £170 £415 £2,338 £1,662
5 £99,153 £171 £414 £2,923 £2,076
6 £98,982 £171 £413 £3,508 £2,489
7 £98,810 £172 £412 £4,092 £2,902
8 £98,637 £173 £412 £4,677 £3,314
9 £98,463 £174 £411 £5,261 £3,725
10 £98,289 £174 £410 £5,846 £4,135
11 £98,114 £175 £410 £6,430 £4,544
12 £97,938 £176 £409 £7,015 £4,953
13 £97,762 £177 £408 £7,600 £5,361
14 £97,584 £177 £407 £8,184 £5,769
...etc
120 £73,924 £275 £309 £70,151 £44,075
240 £30,978 £454 £131 £140,302 £71,279


While at the start the majority of the monthly payment is going towards interest, there is also a £168 reduction in the capital owing.

After only 1 year, you will have paid around £2k off the capital, reducing the interest required by £8 per month - £8 that goes towards paying off capital in the future, in a snowball fashion...until its nearly an even split at 10 years, 120 months.

Interest-Only combined with deliberate overpaying can be a flexible option, but in my opinion consistent, disciplined repayments are a better option that will ensure the mortgage is paid off at the time required. Assuming you do not have an alternative repayment vehicle.

The danger with the "I'll see what I can find when I need to" approach, is that life gets in the way, with expenditure eating into 'spare' cash. Then you get to 55 and realise you need 15 years worth of overpayments in 10 years of employment...

I think one of the concerns is the use of "overpaying" terminology. Some people, rightly, mean paying more than necessary to be ahead of a repayment basis. Others think that paying ANYTHING more than the interest is 'overpaying' - which is not the case, its just 'paying a bit'. Not enough to keep up with repayment, leaving the capital barely touched, shortening the time in which you have to repay the capital.

jamesd

The first one gave the advice that gives you most flexibility. The second one gave the advice for those who lack self-control.

When you start on interest only that means you don't need to beg the mortgage company to reduce to interest only, just need to reduce the regular overpayments that you might make. That's a right that is worth having when times are tough or even just around Christmas and holidays. You can cut them back then, then catch up during the rest of the year, say. Or pay a bit more earlier in the year and reduce when you have a reason to.

For more serious situations like unemployment, dropping back to the interest only payment as a right makes it much easier to deal with the temporary financial stress. That means that any emergency savings you have will last longer, reducing risk for you.

For more banal situations, you can cut the mortgage overpayments back to pay off a car, home improvement loan or credit card faster and save yourself interest that way. Not something you can do to the same extent with a repayment mortgage. Or you can cut the payments back in advance and then make the purchase with cash, then make the "loan repayments" as overpayments on the mortgage, saving yourself the difference between loan and mortage interest rates.

Personally I'd go with the first choice because it's useful flexibility that makes no difference at all to how long it take to pay the mortgage, provided you make the same mortgage payments in each case. If you pay more than the repayment mortgage amount you get the same benefit in both cases.

Sometimes there can be a difference in mortgage interest rate for interest only and repayment. In those cases the interest rate can make it better to take repayment and lose the flexibility of interest only.

If you lack self control, go for repayment. If you have plenty, go for interest only and the extra flexibility.

anandp

I'd agree with James above.

I have two simple rules when dealing with mortgages - and have a few buy-to-lets so can speak to this end.

Own residential property: Always repayment (with the aim being to reduce your overall interest payments over time and build up capital)

Investment property: Always IO (with the aim being to make the most use of your investment capital)

Having repayment on resi property doesn't always restrict overpayments anyway, so if you want to pay off more, you can. However it does force you to start paying off the capital immediately.

If you're lucky enough to be in a position to pay off more than the due mortgage amount every month, then by all means over pay on the repayment mortgage too!

Anand

TighterThanTwoCoatsOfPain

i personally have an interest only mortgage with a 20 year term with an offset facility + unlimited overpayments, despite paying it at a rate which will have it finish about the same time as the long term fix i'm on without eating into any of the offset.

The basis being that i'm disciplined enough to deal with it myself without having to be bound by permanantly high payments.

If the worst happens and myself and wife both lose our jobs we have the option of dropping back to the minimum interest only payment which would save us over £700 if times were hard.

I wouldnt have it any other way, but not for those without a sensible head!

IMO nobody on here can answer the OP without knowing their full circumstances, i'm a little surprised no one said that without making a punt at which was "right"

Lisdeleau

Thanks all - very useful!

dunstonh

The problem is that we dont know much about the OP apart from being a FTB. Most FTBs have limited capital in the early years and most of the expenditure comes then as well. So, going interest only with overpayments is risky from the point of view that you have to be really disciplined and you need to really be doing more than the capital and repayment mortgage to benefit.

The idea is sound but the reasoning given is flawed.

An experienced borrower later on may do it. I do it for example. I have an interest only mortgage that I part use Stocks and Shares ISAs to offset and part overpay on the monthly. However, I personally would be wary with a FTB doing it.

CloudCuckooLand

I don't understand the mindset of those who choose to put a holiday, Xmas, car, or general accumulation of credit card debt etc ahead of keeping a roof over your head.

If your financial situation is so borderline, then have a smaller car, take a shorter holiday etc etc...the 'roof' will last throughout retirement, so it is worth some sacrifices.

Risking a more expensive re-mortgage, due to poor LTV, is a also no-no, in my book. Repayment ensures progress is made against capital. Although not enough to compensate against the recent price crash, it can at least offset what those on IO are often finding is complete immobility of product.

And to risk prolonging what is already a very long-term product, usually 25yrs, into the realm of retirement is not something I would contemplate. My aim, having first bought at 25 is to end the term at 50 and I then have 15 years of the old mortgage payments going into my retirement fund.

The banks get plenty of interest, I don't want to give them more than I need to.

jamesd

Dunstonh, I wouldn't want to rule out a FTB doing it, in part because I may, but with pension, ISA and non-ISA investment backing. Does take very careful consideration of the psychology of the borrower, though.

CloudCoockooLand, it's not a borderline financial situation but cutting down on the use of more expensive borrowing that some might otherwise do. If you don't use car loans or home improvement loans then there's nothing to gain from reduced future borrowing costs, but many people do do those things and can save interest by repaying them faster and effectively paying the mortgage interest rate instead of personal or car loan rate. You do need the self control to only spend what you can afford, as with life in general. That mortgage does have to be paid off somehow, after all.

No more expensive remortgage, because the same payments as repayment should be used, or overpayments beyond that. Assuming the only reason for interest only is extra flexibility, not reducing outgoings in the initial years or using investments to repay.

You're right that some might do it because they are borderline, but that's not necessarily the case. If it is borderline then it's worth considering whether getting a mortgage at all is wise, not whether interest only but repayment level payments on it is better than straight repayment.