Update: read
The trouble with interest-only mortgages
for more on why you should avoid an interest-only mortgage.
In 2003, 450,000 people took out two-year fixed-rate mortgages. They are all going to have to remortgage this year, and that’s going to give them quite a shock. Short-term interest rates averaged about 3.75% two years ago. Now they are 4.75%, 26% higher. And the betting is they’ll be 5% soon enough. So what kind of rate will the remortgagers end up with? Those who shop around could re-fix for two years at about 5.75% (including all fees), or they could switch to a tracker, some of which only ask the base rate of 4.75%. For someone with an interest-only mortgage, however, this still means monthly outgoings could jump the full 26%. And if rates do rise as expected, spare a thought for those who got their fixed-rate mortgages late on in 2003 when rates were at 3.5%. If they have to remortgage at 5%, they can expect to face rises in their monthly mortgage payments of 40%. No wonder consumption is slowing sharply.
All this will make it very tempting for borrowers - even those who currently have repayment mortgages - to switch to an interest-only loan to cut their payments, especially if they’re only planning on staying in the house for a few years. Some of these borrowers will remember the old claims about interest front-loading on repayment mortgages. This is the belief that interest payments tend to be front-loaded (you pay them before you start paying off the capital), so after five years, while you’ve paid out a lot more than you would have with an interest-only mortgage, you still owe nearly as much. There used to be some truth in this argument - back when interest rates were in double-digits - but these days, with low rates and low inflation, there is none.
To understand why, we need to look at the mathematics of calculating annuities (as payments of capital and interest) compared with payments of interest only. Imagine that over a 25-year term loan, on top of the interest, you’d need to repay 25 equal amounts of capital each equating to 4% of the total. If you took 4% a year off your loan principal, by half way through the 25 years you’d only owe half as much and so your interest payments would have halved. Instead, the lenders structure the loan (mathematically) as an annuity so that your monthly payment is the same every month to maturity - by which time the loan is paid off. The mathematics of this arrangement mean that the amount of capital you have actually paid back varies greatly according to the interest rate payable. For example, for a 25-year repayment mortgage at a rate of 5%, only 2% of the loan is repaid in year one, and this will rise slightly every year for the whole period, so that the average repayment amount is 4% of the total loan. After five years, then, 20% of the loan period has run, but only about 12% of the original debt has been paid off. A decent chunk, admittedly, but not as much as most people might have thought.
But that’s nothing compared to the shock borrowers used to get. In the days of 15% interest rates - thanks to the huge mathematical impact of compounding large numbers - it really was true that after five years you had paid off virtually nothing. With a 25-year loan at 15%, rather than 5% interest rates, the year one repayment is just 0.37% of the total loan size! After five years, you might only have paid off a measly 2% of your mortgage. This helps us see why Einstein once exclaimed that the only puzzle in maths that truly astounded him was the miraculous effect of compounding.
Somehow, the remembrance of this dismal situation has remained in the public psyche, even though it’s no longer valid in this era of low interest rates. However, one other false idea has been added to the myth - that in the days of high double-digit rates, you didn’t actually pay more for a repayment mortgage. A 25-year repayment mortgage at 15% requires annual repayments equivalent to just 15.37%; the additional 0.37% is all that’s required to pay off the loan over time. But with low rates, there’s a much lower compounding effect, so much heavier repayment contributions need to be made. A 25-year repayment mortgage at 5% rates requires annual repayments in excess of 7%.
So there it is. In today’s low inflation (low interest-rate) environment, you actually have to pay off your debt, which is still likely to be considerable in real terms, even after the 25-year term of the loan. As such, your monthly payments need to be quite significantly higher than the interest rate alone would suggest. Back in the old days of high inflation, you may have faced higher interest rates up front, but properties were consequently cheaper and the real value of the loan was inflated away so that ultimate repayment was less of an issue. I’m not sure which era was the better, but one thing’s for sure. If popular mythology can be so wrong on the changes low rates have wrought on the repayment profile of mortgages, perhaps too many people still believe they don’t have to worry about repaying their mortgage capital; that somehow inflation will magic it away, as it always has in the past. If that’s the case, the rise in popularity of the interest-only mortgage is the harbinger of a future housing-payments shortfall that will make the endowment scandal story look like a fairytale.
Published in Personal finance
| More articles
by
James Ferguson
FREE - MoneyWeek's daily investment email
Our free daily email, Money Morning, is an informative and enjoyable analysis of what's going on in the markets. Written by our Editor, John Stepek, and guest contributors.
Sign up FREE to Money Morning here.
