It can be daunting applying for a mortgage, and even more daunting determining how much you have to pay for the loan. Many people find this difficult. Financial advisors and banks will provide guidance, but usually only for the products you have chosen and will not necessarily provide guidance about risks or build in predictions about inflation or change in interest rates.
One type of loan is an interest only loan and this article will deal with the basis of such a loan. These types of loans are available in both the US and UK and the financial principles are similar, although they are primarily investment vehicles and not usual for domestic property. In Canada they are restricted and only available for the first few months of a loan.
Interest Only Mortgages
These loans involve just paying the interest on the loan amount (which is a proportion of the property value) over a period of time, and not paying off its capital value, sometimes called the "principal". In some countries these mortgages are illegal or can only be obtained only under special circumstances, because they mean that at the end of the loan period the borrower has to fund the original cost of the property from other sources, or risks losing it. For an investment mortgage, such as a buy to let mortgage (jn the UK) it may not matter – the aim is to purchase a property, obtain rent from it for a few years, and then sell at a profit, and not retain it for ever. However for personal home loans it can be dangerous unless well thought out.
In some situations, interest only terms may be allowed for the first few years when borrowers might find payments difficult, so they only need to pay interest After that, the mortgage is transferred to a capital repayment mortgage, where the capital value of the loan is paid back over the remaining time.
Mortgage Calculator
For an interest only mortgage, if the original purchase price of a property was $250,000 and a buyer placed a $50,000 deposit, they would owe the bank $200,000. They pay interest on this remaining $200,000 for the term of the mortgage which could, for example, vary from 5 to 25 years.
- If the interest rate is 5% per year, they pay $10,000 a year interest on a $200,000 mortgage loan.
- If the term of the loan is 20 years, then they would pay $10,000 x 20 or $200,000 in interest over the full period of the loan.
- In addition they would have to pay $200,000 (the amount of the original loan) at the end of the 20 years if they do not wish to risk losing the property, so they need to save this in parallel.
- This would make the total payment $400,000 over 20 years.
Money Inflation
This may seem a raw deal, and in some cases it is, but there are advantages.
- The early years are cheap. The borrowers may be bringing up a family and need the additional money in the early years.
- Inflation may mean that in fact the $200,000 capital repayment at the end of 20 years is not so much in real terms, for example, if inflation is at the rate of 5% per year, the amount owed is equivalent to around $75,000 in the original money.
- The cost or interest rate is calculated in terms of the original purchase price not adjusted for inflation. This means that if there is inflation over the period of the loan, the amount of interest paid in real terms reduces if the interest rate remains stable. For example, over a 20 year period, if there is inflation at the rate of 4% per year, $10,000 would be worth $4,746 after 20 years.
- It is often possible to change to capital repayment after a few years. If inflation is high or the borrower’s income has improved then paying off some capital after the early years might be easy.
- There is more flexibility as financial circumstances change.
As an example, consider an interest only mortgage at a fixed interest rate of 5% with inflation at 4% over a 20 year period on a $200,000 loan.
- The amount of interest , taking inflation into account in terms of the original purchase price, over the term would be $141,339. This is because the actual amount of interest each year ($10,000) represents less in real terms because of inflation.
- The original loan of $200,000 is equivalent to $91,277 after 20 years, because of inflation.
- Hence taking inflation into account you only pay $232,617 over this period, in real terms, for a $200,000 loan.
It seems too good to be true, and this only works if the borrower has strict discipline to save up the money and can weather storms. In addition interest rates may change and inflation may go up and down over 20 years, so it is impossible to predict what will happen over the term of the mortgage. Therefore illustrations of costs at “today’s values” probably do not truly reflect the costs or risks of such a mortgage loan.
Considerations for Interest Only Loans
Considerations for taking out such a loan are as follows.
- Do you have the financial discipline to save up the original amount of the loan if necessary?
- Can you easily change to capital repayments after a few years without financial penalty?
- Is the interest rate fixed, and if so for how long, or is it variable?
- What is the term of the loan in years (the longer, the more flexibility you will have but the more interest you will pay)?
- Are you sufficiently alert and flexible to be able to adjust your borrowing in later years of the mortgage according to inflation, interest rates and your personal circumstances?
- Lenders may quote higher interest rates for such loans compared to capital repayment loans, or have more stringent lending criteria, does this cause you problems?
- Do you wish the loan for an investment (e.g. renting property or a second home) or will this be your main residence?
Remember that for most interest only loans you can redeem or pay off the entire loan at any time, although there are sometimes financial penalties for early redemption.
An interest only mortgage is a useful alternative to a traditional capital repayment mortgage but although it may seem simple and relatively cheap financially should only be considered if one has a good grasp of both the risks and opportunities and is financially knowledgeable.
Richard Brereton - Richard has a PhD, MA and BA from Cambridge, is a chartered chemist, Fellow of the Royal Societies of Chemistry, Medicine and Statistics ...
Join the Conversation