4.6 Interest-only mortgages and the balance sheet
You have seen in the interactive activity in Section 4.3 that, with a repayment mortgage, income is used to pay off part of the mortgage loan each month. This reduces the mortgage liability over time. But what is the effect on assets and liabilities of an interest-only mortgage?
Activity 14 Balance sheet with interest-only mortgage
Allow about 10 minutes
Piotr buys a home with an interest-only mortgage and also starts to save regularly into an investment plan that he will use to pay off the mortgage at the end of its term.
- Select, from the following options, two effects of this arrangement on Piotr’s balance sheet at the start of the mortgage term.
Discussion
The correct answers are:
- An increase in liabilities
- An increase in assets
Assets increase by the value of the home. However, this is offset by an increase in liabilities.
- Select, from the following options, two effects of this arrangement on Piotr’s balance sheet during the mortgage term.
Discussion
The correct answers are:
- No monthly reduction in liabilities
- Monthly increase in assets
With an interest-only mortgage, there is no monthly reduction in liabilities during the period of the loan. The monthly payments are made up only of interest; none of the loan is paid off.
There will be a monthly increase in assets as payments are made into the investment plan. (Although, if the value of the investments can go up and down, we cannot rule out a fall in value in some months.)
- Select, from the following options, two effects of this arrangement on Piotr’s balance sheet at the end of the mortgage term.
Discussion
The correct answers are:
- A reduction in liabilities
- A reduction in assets
At the end of the mortgage term, both assets and liabilities will reduce as the loan is paid off by cashing in the investment scheme. However, there will usually be no guarantee that the value of the investments is sufficient to pay off the loan in full.
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