Comparing the costs of interest-only with capital repayments

Let's first look at a simple example.  Take a £50,000 mortgage with a lender who charges a nominal 7% pa interest with monthly rests, and for simplicity, assume the interest rate remains unchanged for 25 years.  MIRAS (Mortgage Interest Relief at Source) no longer operates as from April 2000, so it can be totally ignored:  the gross cost, before tax relief, is now the same as the net costs.

So you pay less to the lender with an interest-only loan, but the capital to repay the loan at the term end must be saved up from a separate investment plan.  Supposing you take an interest-only mortgage but invest the £61.72 "saved", by not taking a capital repayment mortgage, in some investment scheme. 

We have made the total monthly costs the same as that for a capital repayment mortgage. 

Suppose the investment plan achieves a growth rate of exactly 7% pa, compounding monthly after any tax and fees, precisely the same rate as the mortgage interest.  What will £61.72 per month for 25 years @ 7% pa achieve?

The answer, as you probably suspected, is £50,000, exactly sufficient to repay the loan.  The two methods have not only cost the same month by month, they produce exactly the same end result, accepting some rounding.  Mathematically it is obvious that they would, since the cashflows are identical and the IRR’s are identical.

Higher or lower growth than the mortgage rate
Now, instead of growing at exactly the same rate as the mortgage, suppose the investment grew by more, say 8% pa:  it would then be worth £58,697 in 25 years time which is a surplus of £8,697 over and above repaying the mortgage.  This surplus has been achieved without having to pay out any more per month than an equivalent repayment mortgage, so it is a genuine windfall, tax-free.

But, if the investment only made 6% pa overall, it would mature for only £42,771 leaving a shortfall of £7,229 from the £50,000 needed to repay the debt - not exactly a good deal.  Equally as important, even if the investment grew by more than 7% pa, but the amount saved each month was insufficient, you could still not achieve the required amount in 25 years time.  This is the kernel of the endowment mortgage scandal – the monthly investment proved insufficient to even repay the mortgage, let alone provide a surplus.

Compare the IRR
Note also that any surplus or shortfall from the investment is only relevant at the end of the mortgage, 25 years in this example, when it is eventually realised.  To put this timing aspect into context we can calculate the IRR of the mortgage taking into account the surplus (or shortfall) from the policy at the end.  These can be done using the “Loan Comparator” spreadsheet supplied and entering a negative redemption charge for the surplus.  The lower the IRR the better. 

If we work out the IRR for these four cash flows, each with identical month-by-month costs, it would be as follows: -

In this example, a 1% pa difference in performance on the investment return is very roughly equivalent to around a third of a percent off the nominal interest rate of a repayment mortgage when you look at the deal as a combination of cash flows.

Compare the NPV
Another way of comparing returns is to look at the equivalent NPV, or Net Present Value, of the interest-only figures compared with the repayment mortgage.  The table below reflect the same figures as before.

So a capital repayment mortgage would have the same value-for-money as the interest-only + 8% investment provided you also received a £1,161 cashback.  Conversely, if the investment made only 6%, it was as if you threw away £1,181 at inception.

A spreadsheet entitled “Investment and Mortgage Calculator” is included to make this mathematical point for any chosen set of circumstances.

Investment returns must exceed mortgage interest
In general, to be worthwhile, an investment set up expressly to repay an interest-only mortgage must outperform the mortgage interest over the full term - net of tax and charges.  What is the chance of that happening in practise?  How do you go about selecting an investment scheme, particularly one likely to beat mortgage interest?