Interest only mortgage guide
Find out the pros and cons and why you might want to consider an interest only mortgage.
What is an interest only mortgage?
With an interest only mortgage, as the name suggests, you only pay back the interest on the loan each month. You don't 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, but you’ll need to have the money to pay back the entire loan at the end.
Of course, this type of arrangement presents a bigger risk for yourself and the lender. Therefore lenders will only agree to provide you with an interest only mortgage if they're confident you'll have the ability 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, therefore, lenders will want to understand how you intend to pay back the loan. This is known as the ‘repayment vehicle’.
The most common ways that people do this are:
Cashing in on stocks, shares, ISAs, or savings
Selling other properties you may own
Selling the property being purchased (with some lenders this can also be an acceptable payment vehicle)
Through pensions, endowment policies, and investment bonds
If, by the end of the mortgage term, you don't have sufficient funds available to pay back the loan amount, you may find yourself having to sell the property to pay the mortgage off.
Advantages of an interest only mortgage
The principal advantage of paying a mortgage on an interest only basis is, of course, that your monthly payments will be significantly lower than those for the equivalent repayment mortgage
There are other benefits too:
There’s less chance of you getting into arrears on your mortgage.
It's a relatively low cost way of getting a foot on the property ladder.
If you have additional money available, it’s often possible to overpay on an interest only mortgage, depending on the product and criteria. Any such overpayment is deducted from the capital outstanding, reducing the debt to be repaid at the end.
There are potential tax advantages associated with interest only mortgages in the case of buy-to-let investors.
Disadvantages of an interest only mortgage
The main drawback of this type of mortgage is that, as you’re only paying the interest on your loan, at the end of the term you’ll still owe all of the original sum borrowed.
Other downsides include:
You may need to use savings, investments, or other assets you have to pay off the total amount borrowed at the end of your mortgage term. This could leave you short of cash for your retirement or other projects.
Even if you put money into an investment plan over the life of the loan, it may not be worth enough at the end to pay off the debt in full.
You might not be in a position at the end of the term to repay your original mortgage amount.
Some people count on rising property prices, then plan to sell at the end of the mortgage and pay off the loan while downsizing to a smaller property. But you can't rely on rising property prices to pay off the loan as they may fall. You’d then have to sell the property and make up the difference in value to repay the mortgage
If you find yourself in a negative equity situation wherein your mortgage is more than your property is worth, you may find it hard to remortgage your home.
You could end up paying more interest overall over the term of your mortgage compared to a repayment mortgage.
Why switch to an interest only mortgage?
As we've already seen, this type of loan means your monthly payments should be lower because you’re not paying back the capital. However, you need to factor in that on a variable rate mortgage, payments can still increase when interest rates rise. Whether it's on a fixed rate, tracker, or offset mortgage basis, it’s become harder to get an interest only mortgage since the financial crisis of 2008. Lenders now expect to see solid evidence as to how you intend to repay the loan, and will ask to see this at the application stage. A promise of a windfall or inheritance at some future date isn’t enough; lenders will expect to see an approved investment vehicle - such as an ISA - and will check to see that it's on track to pay off the loan when you remortgage.
More information about interest only
Interest only mortgages are more common in the buy-to-let space, where the sale of the buy-to-let property can be used 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 contribute directly towards reducing the capital and therefore the amount that you’ll have to pay back at the end of the mortgage term.
Some high street lenders as well as some smaller firms provide interest-only mortgages, while they tend to require at least a 25% deposit.
Types of interest only mortgage
Fixed rate mortgage
It's possible to 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. However, at the end of the initial fixed period, you’ll go back to the Standard Variable Rate (SVR) - unless you choose to remortgage - and this could mean an increase in your payments.
An alternative is a tracker mortgage which follows a well-known rate such as The Bank of England’s interest rate, giving you some certainty regarding rate movements. Your repayments will rise as rates rise, but they’ll also fall if rates fall. Trackers are usually a few percentage points above the rate they’re tracking.
Another popular choice is an offset mortgage. Here your mortgage loan is linked to a savings account. With this type of product, you don't 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 have the means to pay off the loan at the end of the term. So it’s a good idea to start putting cash aside if you don’t have a valid repayment vehicle.
Providing you can afford to, it may be worth switching your interest only mortgage to a repayment mortgage. This is a simpler option when it comes to slowly paying off your mortgage.
You should also consider part-interest-only part-repayment mortgages, which would mean your monthly payments don’t rise significantly but you’d still pay off some capital.
You should be mindful 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 internally, so it’s worth discussing your options with your current provider as well as a mortgage broker.
House price gains
Whether you can remortgage, and how competitive a deal may be, depends on how much equity you hold in your property.
In many parts of the UK, house prices have increased significantly in the past five years. This generally makes it easier to remortgage, even if you’ve held an interest only mortgage without saving or investing.
House prices average at £234,853 in August 2019, up from £164,716 in January 2013.
However you shouldn’t 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 - creating so-called mortgage prisoners.
Interest only lifetime tracker
If you already have an extremely competitive mortgage deal, it may be hard to find a more competitive deal today.
For example, you might have secured an interest only lifetime tracker mortgage before the credit crunch which tracks the Bank of England’s Bank rate.
In this situation it may be worth using the monthly savings from your current deal to invest elsewhere so you’re able to pay off the capital at the end of your mortgage.
Bear in mind that your investment won’t be guaranteed to grow, and 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 sometimes sold as ‘cheaper options’ than capital and interest mortgages between 2004 and 2008, because of the lower monthly payments.
There was an assumption in some cases that house prices would rise, which made it especially problematic when they fell between 2007 and 2009.
If you have an interest only mortgage and don’t feel your broker made it clear what you were getting into, you can complain to the Financial Ombudsman Service.
There are also commercial firms that specialise in helping you make interest only mis-selling claims.
The key factor is whether the risks about interest only were made clear to you, as the adviser should have told you that you need to establish a payment vehicle at the end of the term and not to rely on house price gains.
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