What is an interest only mortgage?

With an interest only mortgage, you only pay back the interest on the loan each month.

You do not pay back the money you borrowed to buy the property (the capital) until the end of the mortgage term.

This means that your monthly payments are much lower than if you had a repayment mortgage. Remember, you’ll need to have the money to pay back the entire loan at the end.

An interest only mortgage is a bigger risk for you and the lender. So the lender will only give you one if they're sure you'll be able to pay the full amount back at the end of the mortgage term.

There are strict guidelines to ensure responsible interest only lending.

Before taking out an interest only mortgage, lenders will want to know how you plan to pay back the loan. This is the ‘repayment vehicle’.

You can show how you plan to pay back the loan by:

  • cashing in on stocks, shares, government scheme ISAs or savings

  • selling other properties you may own

  • selling the property you're buying (this is an acceptable payment vehicle to some lenders)

  • showing pensions, endowment policies, and investment bonds

If you do not have enough to pay back the loan at the end of the term you may have to sell the property to pay the mortgage off.

Interest only mortgage deals

We base these deals on securing a mortgage of £181,600 on a £227,000 property (that's 80% loan to value) over a 25 year term. We’ve searched for the most competitive deals using the true cost.

True cost includes:

  • capital and interest repayments

  • fees

  • incentives due over the initial period of the deal

True cost is a more effective way of comparing deals than looking for the lowest interest rate deal.

2 year fixed deal (first-time buyer)

£6,769.72

True cost over initial period

£230.03

Monthly payment

Details

Based on securing a mortgage of £181,600 over a 25 year term. Includes £1,249 upfront fee. 1.52% initial rate reverts to 5.74% SVR after initial 25 month period, costing £868.65 per month for 275 months.

Total amount payable is £427,618.50 including interest and fees. That's a 5.40% APRC. True cost based on a 24 month period. This deal was last updated on 1 March 2019.

2 year fixed deal (remortgage)

£6,519.72

True cost over initial period

£230.03

Monthly payment

Details

Based on securing a mortgage of £181,600 over a 25 year term. Includes £999 upfront fee. 1.52% initial rate reverts to 5.74% SVR after initial 25 month period, costing £868.65 per month for 275 months.

Total amount payable is £427,368.50 including interest and fees. That's a 5.40% APRC. True cost based on a 24 month period. This deal was last updated on 1 March 2019.

Advantages of an interest only mortgage

The main benefit is that your monthly payments are much lower than similar mortgages.

Other benefits include:

  • it's less likely that you'll get into arrears on your mortgage

  • it's a cheaper way of getting on the property ladder

  • being able to overpay on certain products if you have more money available. Your overpayment is taken from the capital you owe, reducing the debt you have to pay at the end

There could be tax advantages with interest only mortgages for buy to let investors.

Disadvantages of an interest only mortgage

The main downside is that you'll still owe the full amount of what you borrowed. This is because you’re only paying the interest on your loan.

With an interest only you may:

  • need to use savings, investments or other assets to pay off the total loan amount at the end of your mortgage term. This could leave you short of cash for retirement or other projects

  • still not have enough to pay off all the debt if you put money into an investment plan over the life of the loan

  • not be able to repay your original mortgage loan at the end of the term

  • not be able to pay off the loan afterwards if you plan to sell at the end and downsize. It's not a guarantee that property rates will increase. You’d then have to sell the property and pay the difference in value to repay the mortgage

  • end up in negative equity where your mortgage is more than your property is worth

  • pay more interest in total over the term of your mortgage compared to a repayment mortgage

Why switch to an interest only mortgage?

Monthly payments might be lower but can still go up if the interest rate does if you're on a variable rate mortgage.

It’s harder to get an interest only mortgage since the 2008 financial crisis. Whether it's on a field, track or offset mortgage.

Lenders now ask to see evidence of how you plan to repay the loan, at the application stage.

A promise of a large amount of money or inheritance at some future date is not enough. Lenders will expect to see an approved investment vehicle such as an ISA. They'll check to see that it's on track to pay off the loan when you remortgage.

More about interest only

Interest only mortgages are more common for a buy to let.

You can use the sale of a buy to let property as the repayment vehicle.

You can also choose to make overpayments, either as a lump sum or on a regular basis if you can afford it. These will go towards reducing the capital and how much you’ll have to pay back at the end of the mortgage term.

Some high street lenders and some smaller firms offer interest only mortgages. They'll often need a deposit of at least 25%.

Types of interest only mortgage

You can get a fixed rate mortgage which ensures there are no changes in repayments for a fixed period of time. This is good for stability and helps with financial planning.

At the end of the initial fixed period, you’ll go back to the Standard Variable Rate (SVR). This could increase your payments but you can remortgage to see if you can find a new deal.

A tracker mortgage follows The Bank of England’s interest rate. This gives you some certainty about rate movements.

Your repayments will rise as rates rise, but they’ll also fall if rates fall. Trackers are often a few percentage points above the rate they’re tracking.

An offset mortgage links your mortgage loan to a savings account.

You do not get interest on your savings but they go to offset the loan. So the more you save, the less you pay on your mortgage.

You can also put the money in your savings account towards paying off the capital at the end of the term.

Managing my interest only mortgage

If you already have an interest only mortgage you’ll need to make sure you can pay off the loan at the end of the term. So it’s a good idea to start putting cash aside if you do not have a valid repayment vehicle.

Remortgaging

It may be worth switching your interest only mortgage to a repayment mortgage if you can afford to. This is easier when it comes to paying off your mortgage over time.

You should also consider part interest only, part repayment mortgages. This means your monthly payments do not rise much but you’d still pay off some capital.

Be careful of any early repayment charges you’d have to pay if you switched mortgage deal.

Some lenders make it easier than others to switch your mortgage deal with them. It's worth talking about your options with your current provider as well as a mortgage broker.

House price gains

The amount of equity you have in your property will determine if you can remortgage. As well as how competitive the deal could be.

In many parts of the UK, house prices have increased a lot in the past five years. This often makes it easier to remortgage, even if you have an interest only mortgage without saving or investing.

House prices average at £234,853 in August 2019, up from £164,716 in January 2013. Do not bank on house price gains, as they fell from £190,032 in September 2007 to £154,452 March 2009.(1)

This caused some people’s loans to become bigger than their property. This created so-called "mortgage prisoners".

Interest only lifetime tracker

If you already have a competitive mortgage deal, it may be hard to find a more competitive deal.

For example, if you got an interest only lifetime tracker mortgage before the credit crunch. This tracks the Bank of England’s Bank rate.

In this situation it may be worth using the savings from your current deal to invest elsewhere. This will let you pay off the capital at the end of your mortgage.

Remember that your investment is not guaranteed to grow. You may need to look into other ways of paying off the capital at the end of the mortgage term.

Pre-credit crunch mis-selling

Interest only mortgages were mis-sold as cheaper options than capital and interest mortgages. This was between 2004 and 2008. The mis-selling was due to the lower monthly payments.

There was an assumption that house prices would rise. This was made worse when they fell between 2007 and 2009.

You can complain to the Financial Ombudsman if you have an interest only mortgage and feel your broker did not make it clear what you were getting into.

There are also commercial firms that can help you make interest only mis-selling claims.

The key factor is if your adviser were clear to you about the risks of interest only. The adviser should have told you that you'd need a payment vehicle at the end of the term. As well as not to rely on house price gains.

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