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 Relax with a repayment...from Complete guide to Homebuying December 2002 ...or save money with an interest-only mortgage. Which will you do? Complete guide to Homebuying helps you decide You've reached a fork in the road on your way to the perfect mortgage. One road leads to an interest-only deal, the other to a repayment mortgage - you could take a middle way, it is possible to mix and match, but most borrowers choose one or the other. How do I decide which way to go? With an interest-only mortgage you pay only the interest each month but defer repayment of your actual loan. So if, for example, you borrow £70,000 on an interest-only basis and make the minimum monthly payments you still owe £70,000 at the end of the mortgage term. At some point you need to find some money to cover your debt: you could use an inheritance or take out an investment and pay into that each month. With a repayment loan - sometimes called a capital and interest mortgage - your monthly payments clear some of the money you owe and some of the interest. As the months go by the capital you owe is reduced so that at the end of your mortgage term there is nothing left to repay. So a major factor in your choice will be your attitude to risk. "If you want to be in the position that your mortgage will be fully paid off at the end of a specific period you should opt for a repayment mortgage," says David Bitner, technical manager, mortgages, at IFA the Marketplace. "It is effectively guaranteed that you will pay it off." The only thing that will prevent you clearing the mortgage within your chosen term is you defaulting on your payments. So it's all down to risk? Not all, no. Another factor to bear in mind is your financial position. If you expect to earn more in the future or need to spend money on your house in the early years, you will probably be looking to reduce the amount you spend on your mortgage. Neil Franklin, partner at IFA Franklins Financial Services, says: "Maybe paying interest-only for a while makes a lot of sense when you have a house to set up." The monthly payments on an interest-only deal invariably lower than on a repayment deal, but how much lower depends on the size of your mortgage and the rate you are paying. Take a £80,000 mortgage with an interest rate of 5 per cent taken out over 25 years: run on a repayment basis the mortgage will cost £467.67 a month, on an interest-only loan the monthly cost will be £333.33. That's a saving of £134.34 each month - a considerable amount to put towards furnishing and decorating your new home. However, if interest rates rise your savings will fall - on a mortgage rate of 8 per cent the saving is just £84.12. And remember if you need to use an investment to repay the mortgage you may have to make some monthly repayments into that, too. But if I get a pay rise I will be able to cover the extra costs anyway, won't I? And you might be able to make more of an interest-only deal. "The pattern of your income should be a factor in your decision," says Simon Holdsworth, managing director of Towry Law Mortgage Services. "If you have a flat wage - you receive the same each month and it is unaffected by commission or bonuses - a repayment deal may be attractive because you can repay the same each month." If, on the other hand, you do receive lump sum payments on top of your basic salary, Holdsworth suggests you may prefer to take an interest-only deal and make overpayments as and when you can afford them. These will reduce the capital you owe. Similarly if your pay increases you can overpay each month to reduce the capital you owe. Is it possible to make these overpayments on any sort of mortgage? Flexible mortgages offer borrowers the most opportunity to vary their monthly payments - most of these allow lump sum overpayments and regular overpayments, as well as the chance to reduce your payments if you need to. If you choose a flexible mortgage, says Neil Franklin, there is no reason to run it on a repayment basis. By choosing an interest-only loan, he says, "the mature borrower can choose to repay the mortgage at whatever speed they feel is appropriate." However, you don't necessarily need a fully flexible mortgage to do this. Many lenders now allow borrowers with conventional mortgages to repay up to 10 per cent of the capital each year without penalty. Among them are Halifax, Cheltenham & Gloucester and Abbey National. Northern Rock allows you to reduce your capital by up to 15 per cent a year without any redemption fee, Stroud & Swindon allows you to pay down up to 25 per cent, and Ipswich Building Society allows a capital repayment of up to 50 per cent within any special offer period. If you chose the society's two-year discount rate - currently at 4.15 per cent - you could repay half your mortgage in the first year and none in the second, or split the 50 per cent any way you choose. That's a lot of bonuses. What if I don't have any, how do I repay my debt? Traditionally interest-only mortgages have been backed with some kind of investment vehicle. The most popular investment was the endowment and most lenders sold these in a package with the loan. The endowments had fixed terms and were scheduled to pay out at the end of the mortgage term. However, in recent years endowments have underperformed and many homeowners have been unfortunate enough to receive letters saying that their endowments are not on target to repay their mortgages. Endowments have gone out of fashion - it is still possible to arrange one but few lenders are advertising them and their inflexible nature makes them unattractive. Individual Savings Accounts (ISAs) offer more flexibility - you can choose one maxi ISA and continue to pay into each year, choose up to three mini ISAs and retain them for the term of your mortgage, or choose a different ISA or ISAs each tax year. Furthermore you are not locked in for a set term. According to Neil Franklin: "When you take out an ISA you get the opportunity to make day-to-day, week-to-week and month-to-month decisions." This is good news if your investment outperforms in the early years. "If at some point you have got some gains it may be worth cashing it in and paying down on your mortgage," says Franklin. You don't have to wait until the end of the mortgage term, hoping that the investment keeps its value. How do I choose which ISA? Once again it's down to your attitude to risk. Charles Ansdell, spokesman for IFA group Inter-Alliance, recommends a cautious approach. "It's a good idea not to go for high-risk investments," he says. "If anything goes wrong you could lose your house." He suggests investors consider cash ISAs. "You are likely to be better off putting a large amount into a cash mini ISA rather than putting a small amount into a more aggressive fund," he says. But while this could mean the difference between a growing investment and losing your entire pot if the aggressive fund fails to perform, it could defeat the object of backing the mortgage with an investment. The best rate available on cash mini ISAs is 4.65 per cent, available on Kent Reliance Building Society's 30-day notice ISA. If rates stay at this level you will need to invest a considerable amount each month to build up a fund big enough to repay your mortgage. For example, to repay a loan of £80,000 in 25 years time you will need to pay £141 a month into the account. Obviously, rate may increase and you may be able to reduce your payment but to be sure you meet your target in the early years you will have to make large payments. "People choose an invest-backed mortgage on the expectation that the amount they will earn on the investment is greater than the cost of their mortgage," says Neil Franklin. In this instant it may be cheaper to take out a repayment loan. Alternatively you could just overpay on an interest-only deal and keep your options open. "At the moment you will be better off paying off your mortgage than investing in the stock market," says Franklin. "But at some stage that cycle will change and you will be better off investing in the stock market." When that happens, you could look to invest in a stocks and shares ISA. Are there any alternatives to ISAs? "You can use virtually any type of investment to repay the loan," says the Marketplace's David Bitner. "Including the eventual sale of the house." Although this means you could in theory invest in lottery tickets or fine wines, most people will use more conventional investments. After ISAs, employee share schemes and personal pensions are the most popular choices. Like an ISA a pension is a tax-efficient way to back your mortgage, however unlike an ISA it is inflexible. Investments in a personal pension cannot be accessed until you turn 50 which means no opportunity to repay your mortgage early. Currently just 25 per cent of the fund can be taken as a lump sum. This could change by the time you reach retirement but now it means that to repay a £100,000 mortgage you will need a pension fund worth £400,000. Knowing this early on could be useful, says Charles Ansdell. "Often a pension mortgage encourages people to put more into their pension than they otherwise would do," he says. However, it is worth considering the impact that taking a large lump sum could have on your retirement income. The amount left will be used to by an annuity to provide an annual income - the less money left in the fund means a smaller income. Little wonder that Ansdell says: "pension mortgages tend to be the reserve of the more affluent investor." Will the lender want to know how I've chosen to repay my loan? In most cases, no. "Some will ask you to sign a waiver to say that you understand that you have to repay the debt at a given time," says David Bitner. "Because people tend to move their mortgage every three, four or five years the chances of you actually having your loan with the same lender when it's time to repay are minuscule." In theory this means that you could put off thinking about the repayment until the day before it due, in practice this is a very dangerous thing to do. Even if you have taken out an investment to cover the mortgage debt you shouldn't lose sight of how much it is worth. "As far as targeting is concerned people should probably review the investment every three or four years," suggests Neil Franklin. "But obviously the remortgaging time is a good time." Just one last question - aren't interest-only mortgages more portable than repayment loans? "Not any more," says David Bitner. "Lenders used to make what we call annualised interest calculations. Now interest is calculated on a monthly or daily basis." Where interest is calculated annually any payments made on your mortgage won't reduce your balance until the end of the year. If you move your loan half way through the year six months' of repayments are effectively disregarded. In contrast, daily interest calculations means that any monthly repayment, or overpayment, is immediately taken into account. Borrowers who know they are going to move should make sure their interest is calculated daily.
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