Interest only mortgages sound like a good deal when you first come across them. The rates can be cheaper than a regular mortgage. Less money on the mortgage means more money in your pocket!
But this isn’t the complete story. Interest only mortgages are only right for special situations. In this article we’ll discuss more about them.
How are interest only mortgages different to repayment mortgages?
Repayment mortgage
A (regular) repayment mortgage is made up of two items:
- The amount that you initially borrowed that needs to be paid back (called principal)
- The interest that’s charged on the amount that you borrow
On a repayment mortgage your monthly repayment to the lender will be made up of these two items. As you continue repaying the mortgage over time, the interest amount charged on the loan will decrease (because you are paying the debt off).
Interest only mortgage
On an interest only mortgage your monthly repayments will only be
- The interest that’s charged on the amount that you borrow
You do not need to pay back the principal until the end of the mortgage time period (also called the mortgage term).
Calculation example of an interest only mortgage
Here is a practical example of how this works:
John purchased a home for £200,000 with a 20% deposit of £40,000.
The remainder of the purchase price (£160,000) is to be financed with an interest only loan.
John has decided to select an interest only mortgage after discussing the matter with the mortgage advisor.
The lender has quoted John an interest only mortgage covering 30 years.
The fixed rate on the mortgage is 3% for 2 years. After this fixed time period the mortgage rate will revert to a higher rate of 4% unless John remortgages to a cheaper offer.
Interest Only Mortgage Cost
Because John is on an interest only mortgage, he only pays the interest on the mortgage (no principal repayment).
His monthly cost for the fixed rate period is as follows:
1/12 x 0.03 x 160,000
= £400 per month.
In this example, John would not have to repay the outstanding mortgage debt of £160,000 until the end of the mortgage term. But this does mean that John will owe the lender £160,000 at the end even though he will have made payments for many years.
Repayment Mortgage Cost
If John went for a repayment mortgage with the same interest rate of 3% his monthly repayment would be much higher
His monthly cost for the fixed rate period:
= £675 per month.
Cost of interest only mortgages
Interest only mortgages are cheaper per month than a repayment mortgages because you only have to pay the interest on the loan each month.
But there’s a catch.
Because you never reduce the original balance of the mortgage debt, interest only mortgages are generally more expensive over the lifespan of the loan than a repayment mortgage (where you do reduce the mortgage debt over time).
Ways to repay the loan at the end of the mortgage term
When your interest only mortgage term finishes you will need to repay the full mortgage balance that is outstanding.
Some of the more common repayment methods are below:
- Sell the property
One of the most common ways of paying off an interest only mortgage is to sell the home. If the property has increased in value over time, the money from the sale of the property should cover the outstanding mortgage. If the price of the home is higher when you are selling compared to the price you bought it, you will be able to cover the existing mortgage (assuming you’ve paid off all of the interest charged over the time period).
However this is not guaranteed, and if the sale of the property doesn’t cover the outstanding mortgage you may have pay the remainder from your other assets. Some properties in the UK have not increased in value over time and have actually decreased, so this is a risky repayment strategy.
- Remortgage
You can replace the current interest only mortgage with a new mortgage. The new mortgage could be from the same lender or you might find a deal from a different lender. However, you need to check that you still meet the new lender’s requirements when you apply for the new mortgage as you will be older now and your circumstances may have changed since you took out the original interest only mortgage.
Some lenders will not want to provide you with another lengthy mortgage if you are approaching retirement as your income may fall when you finish working.
- Use Your Savings
Some people may build up some cash savings over the time period of the mortgage. If you have enough money saved up, you can use it to pay off your interest only mortgage. However this may have implications for how you live your life if your remaining savings are very low.
- Use an Inheritance
Many people in the UK will receive an inheritance during their lifetime from loved ones that have passed away. Some may decide to use their inheritance to pay off the remaining mortgage debt in the home.
What if you cannot repay the mortgage after the end of the term?
If at the end of the term you cannot repay your mortgage the lender may take steps to recover the property from you. This could result in court action.
If the outstanding debt is not covered by the sale of the property (i.e. if it has negative equity), your other assets may be at risk.
If you are struggling to meet your repayments on the mortgage you should speak to your mortgage lender to work out a solution. You should also consider seeking help from a debt advisor or charity specialising in problem debts like Stepchange.
Can a customer with a regular mortgage switch to an interest only mortgage later?
Most mortgage providers would consider a switch from a repayment mortgage to an interest only mortgage if you choose to do so. However, you must meet the requirements for an interest only mortgage and have a repayment plan to pay off the loan after the end of the mortgage term.
The interest rate charged on an interest only mortgage may be higher than the interest rate for your repayment mortgage.
The lender will carry out their own checks before allowing you to switch. Some of the more common checks include the following:
Your method of repayment:
They will want to ensure that you have a plan to repay the loan when the mortgage finishes.
Source of funds
If you have any new funds that you want to use for the mortgage a lender will check they are from a trustworthy source.
Your credit history
Most lenders will run credit checks to see if your credit score has changed since you took out your first loan.
Your income
Your income will be reviewed so that the lender can be confident the mortgage is affordable. If you are employed this will involve your payslips and bank statements. If you are self employed they will look at your business’s accounts.
Equity
If house prices have been rising in your area during your first mortgage, the value of the equity in your home may also have risen. In this case, the outstanding mortgage on the home might represent a smaller piece of the home’s value.
If your new mortgage represents a smaller loan-to-value (LTV) ratio this time the interest rate charged could be cheaper. You might find that at a lower LTV ratio there are more mortgage offers available to you.
What kind of borrowers take out interest only mortgages?
Landlords
Interest free mortgages are popular for landlords who run a buy-to-let model on their properties. These kinds of borrowers are generally accepted by lenders for interest only mortgages, although there will be exceptions.
Individuals
It used to be common for individual people to take out interest only mortgages for their home, however the checks on these borrowers were not sufficient and following the financial crisis in 2008 a large amount of borrowers were unable to repay their mortgage balances. This hurt lenders financially and so their requirements have tightened up. But it is still possible to get an interest only mortgage as an individual.
Pros And Cons of an Interest Only Mortgage
Interest only mortgages can benefit purchasers who are willing to make larger payments in the future in return for immediate savings. But it can also be a risky adventure in the long run. Let’s take a look at some of the advantages and disadvantages.
Pros
Some of the advantages of the interest only loan are as follows:
- Lower monthly costs
Because you are not repaying any principal in an in interest only mortgage, the monthly costs will be cheaper than a repayment mortgage. If you are expecting to receive a large sum of money in the future (may from a bonus or inheritance) you can use the extra funds to pay down some or all of the outstanding principal when the mortgage period ends.
- Flexibility
Because interest only mortgages have a lower monthly cost, you might decide to use your extra savings towards improving the home.
Cons
There are some disadvantages involved in this type of loan:
- Greater uncertainty and higher risk
Compared to a repayment mortgage, an interest only mortgage is considered a higher risk financing option. Borrowers who take out an interest only mortgage face a high amount of debt to repay at the end of the mortgage period, which can put them in significant financial difficulty.
It’s important to realise that if your home is worth less at the end of the mortgage period, you will not be able to pay off the mortgage debt in full by just selling the property. This means that interest only mortgages are more risky than repayment mortgages.
- Building equity in your home requires more time
Many interest only borrowers rely on a rising housing market to increase the value of their home. It’s important to realise that future house price movements are very unpredictable.
Even if house prices do rise, it can take a significant number of years before this works out at any meaningful growth for the value of your home.
Speak to a mortgage broker
If you’re thinking about getting an interest only mortgage, it’s a good idea to seek independent financial advise from a mortgage broker. Many brokers do not charge a fee upfront and can help you to find the best mortgage product for your situation.
Many brokers will also offer to complete the application process on your behalf.
FAQs
Yes. This is called a hybrid mortgage or a part and part mortgage. It’s essentially a compromise between an interest only mortgage and a repayment mortgage. It will have a cheaper monthly cost than a repayment mortgage but be more than a standard interest only mortgage.