Interest only - are we mad?

bigfreddiel

Nick2000 wrote: »

Hi, any advice from the financially savvy is very welcome…

My girlfriend and I want to buy a bigger house, but we can’t afford it, if it is a repayment mortgage. Should we opt for an interest only or should we stay put?

Look mate, your second paragraph says it all:

.....but we can't afford it,......

so stay put till you can.

simples

fj

geoffky

financial Russian roulette....but all chambers have a bullet in...

jamesd

thaylock, interest only mortgages are also used by those who are investing to repay the mortgage capital in a lump sum later. That's usually more efficient than a repayment mortgage, but it does require having the means and interest to deal with the varying investment returns. Totally different from the situation here, though.

thaylock

jamesd, I take your point - but these people aren't professional investors - they are home owners.

jamesd

Right. And with no repayment vehicle, these days they might be declined for interest only for that reason.

Thrugelmir

jamesd wrote: »

interest only mortgages are also used by those who are investing to repay the mortgage capital in a lump sum later. That's usually more efficient than a repayment mortgage, but it does require having the means and interest to deal with the varying investment returns. Totally different from the situation here, though.

Only advisable where the borrower has sufficent income and or capital to take the risk. I've never seen a more efficent method of repaying a mortgage other than repayment. Any other method is speculation. Which is highlighted by the issues arising from recent lending policy.

What can never be factored is a change in personal circumstances. Over a 25 year period life is full of ups and downs.

mlz1413

Hi Nick2000

Currently both properties are worth £355k and your dream home is £360K so for borrowing an extra £5k + fees you could have your dream home.

I'm guessing the Rental isn't part of this as its your partners pension plan? So even when the mortgage is paid off in 4 years time there is no guarantee of it providing extra income as it will probably need maintaining.

So to buy your dream home you need to take on an IO mortgage at £830pm and will be capable of over paying £170 pm (ie you pay £1000 pm now). With out signficant capital payments (ie salary increases or selling the rental) you will not own this house out right for years.

I'd go for the extention as you can afford this, it will give you extra space, you will pay off mortgage in same time and add value to your current home.

jamesd

Thrugelmir, repayment is probably the least efficient method of paying off a mortgage but it has the advantage of being predictable and that makes it the best choice for most people. There's no tax or investment leverage so there's only a 1:1 ratio of money spent to money repaid. There's also reduced inflation benefit.

Switch to an investment-backed mortgage and you benefit from investment growth that's historically been in the 9-12% range. Over the duration of the mortgage that can significantly increase the amount paid off per Pound of your own money that's used.

Go into a pension mortgage and you benefit from the tax relief of the pension contributions as well as the investment growth, so there's additional benefit that helps both the mortgage and pension income provision portions.

These methods do take an understanding of the investment risks and regular monitoring to adjust investments and funding as needed.

This is completely different from the unaffordable mortgage situation being discussed by the original poster, since prudent use of an investment-backed mortgage would involve making investments comparable to the repayment amount to provide a substantial investment safety margin.

Thrugelmir

jamesd wrote: »

Go into a pension mortgage and you benefit from the tax relief of the pension contributions as well as the investment growth, so there's additional benefit that helps both the mortgage and pension income provision portions.

Not a new idea has been around for years. That was severely knocked by Brown's raid on pension funds with the demise of dividend tax reclaim.

For an average tax payer (on 20% tax rate) to amass a fund of £600,000. In order to ascertain a lump sum of £150k. Its a tall order.

Investment returns on managed funds are also severely hit by management fees. I've had a SIPP for many years and am glad my mortgage was repayment based. The recent demise of BP shows how fragile investment can be.

jamesd

Thrugelmir, yes, it's been around for years. Still a good one because of the combination of tax relief and investment growth but it requires monitoring throughout the years to ensure it stays on track and adjust as needed. It's better for higher rate tax than basic but still works for both.

I doubt that most tax payers would want to go with a pension pot of £600,000 because even after taking out the 25% to pay off a £150,000 mortgage the remaining £450,000 might produce an income in the £18,000 to £27,000 range (at 4% and 6% income) and that's a bit high. Better a mixture of pension and S&S ISA unless the target is £25,000 (including state pensions) or higher in retirement. The ISA part also makes the target lower because 100% of the ISA pot is available.

Starting off with a repayment mortgage it's about £265 a month in initial capital repayment at the start of a 25 year term. The £265 would get you £330 after basic rate pension tax relief and at 7% growth (ignoring inflation) gets you to £258,000 of the target. That's £64,500 off the mortgage with the lump sum and £7,700 or so of pension income (at 4%).

To get to an average pensioner income of around £18,000 a year with £7,000 or so from the state pensions you'd need to add another £3,300 of income, so another £114 in before tax relief pension payments. This takes the pension lump sum to around £92,000 leaving £58,000 to accumulate elsewhere.

£75 a month into an S&S ISA with 7% growth could be expected to produce around £59,000 over 25 years. So:

Start out with £265 from the normal mortgage cost, add £114 to pension and £75 to ISA and you can expect to clear the mortgage and have £11,000 of pension income plus the state pensions. That's a pretty good deal compared to just using a repayment mortgage - just another £189 a month on top of the repayment mortgage cost getting you that £11,000 of pension income.

Even better if your employer is paying in part of the money, if it's done with salary sacrifice so you get some free NI money added or if you're a higher rate tax payer, all of which reduce the amount you need to put in yourself.

7% with no need to account for inflation is pretty cautious since 10% or so plus inflation is what you might historically get before fees from the UK market. So is just 4% income.

But you still need to be willing to take investment risk and monitor it over the years and most people just aren't willing or interested in doing that.