Interest Only Mortgage Explained

Interest only mortgage is exactly what is says… Simply put you only pay interest on the money you borrow and for the duration that your borrow the money. The interest only term can be very misleading in the sense that the idea of the original borrowing is not made clear.

For example, if you borrow $100,000 to buy a property. Your mortgage is for a 20 year period. As an interest only mortgage, assuming an interest rate of 5% … your yearly interest charge on this amount is $5,000. Amortize that over 12 months; your monthly outgoing under the interest only scheme is $416.67.

Your total interest payments for the duration of the mortgage = $100,000.80 At the end of the mortgage period, you still owe the lender the original amount of money which you borrowed. Therefore, what appeared to be an attractive proposition at the outset does not look so good when you do the maths. This is the major draw back with interest only mortgages.

For the purposes of a comparison, consider the same amount of borrowing on a repayment basis:-

Assuming a borrowing of $100,000 over a 20 year period at an interest rate of 5%. Your initial monthly outgoings will be 2x$416.67 per month. Repayment scenario is much more expensive it would appear but you are reducing your capital slowly on a sliding scale. Your last monthly instalment gives you complete ownership of the property in question. Whereas the cheaper of the two mortgage options namely the interest only mortgage leaves you with a liability of $100,000 at the end of your mortgage term. This money has to be repaid as a lump sum to remove the legal charge by the lender which provides his security.

So, what kind of borrower should consider the interest only route?

Clearly, interest only route offers better prospects for short term borrowing. Plus, interest only route gives you access to more borrowing. Therefore, the kind of borrower that this mortgage suits is a developer rather than long term investor like a home buyer with a 20 year borrowing term as illustrated in this case scenario.

Information in the public domain suggests a preference for repayment mortgage over the cheaper alternative that is interest only mortgage. We decided to put that conclusion to a test by conducting a small survey.

1)Payment for a interest only mortgage is $416.67 per month.
2)Payment for a repayment mortgage is double that amount at $833.34 per month.

10 out of 10 people chose the interest only mortgage as their chosen mortgage. However, when we explained the implications of each mortgage in detail. 8 out of 10 people changed their original preference to the repayment one because repayment option offered them greater certainly in the long run. The remaining 2 people were asked why they chose to stick with their choice? Their response was that interest only mortgage offers us more leverage in the short term and it therefore suits our investment criteria.

Finally, home ownership is very long term commitment. Therefore, weighing up all the possibilities is very important. Such a strategy enables you to make your decision with all your information and options to hand. Better decisions are based on good and clear information.