Comprehensive Guide to Interest-Only Mortgages: Pros, Cons & Strategies
In this guide, we will dive deep into the world of interest-only mortgages, explaining how they work, their advantages and disadvantages, and how they differ from repayment mortgages. We will also discuss the history of interest-only mortgages and offer insights into what to do if you have one.
Interest-Only Mortgages: An Overview
An interest-only mortgage is a type of mortgage where your monthly payments cover only the interest charges on the loan and not any of the original capital borrowed. This results in lower monthly payments compared to a repayment mortgage. However, at the end of the term, you will still owe the original amount borrowed, typically repaid as a lump sum. Interest-only mortgages are not the most common form of mortgage loans due to the risks involved for both the borrower and the lender.
Interest-Only vs. Repayment Mortgages
Repayment mortgages involve paying back a portion of the loan and the interest each month, ensuring the loan is fully repaid by the end of the term. In contrast, interest-only mortgages only require paying the interest on the loan, leaving the original amount borrowed still owed at the end of the term.
For example, suppose you borrow £200,000 on an interest-only basis over 25 years at an interest rate of 3%. Your monthly payments would be £500. However, if you opted for a repayment mortgage, your monthly payments would be £948. Although the interest-only option results in more affordable monthly payments, it means that in 25 years, you would still owe the lender £200,000. In contrast, with a repayment mortgage, you would owe nothing and own the property outright at the end of the term.
The History of Interest-Only Mortgages
Interest-only lending soared before the 2008 financial crisis, with customers borrowing on an interest-only basis without showing lenders how the debt would be repaid. After the credit crunch, it became apparent that many interest-only borrowers would struggle to pay off their loans. As a result, it is now challenging to obtain an interest-only mortgage, and lenders offering such loans have strict criteria, including a decent deposit and an approved repayment vehicle in place.
Advantages of Interest-Only Mortgages
Some of the most prominent advantages of interest-only mortgages include:
- More affordable monthly payments: Since you’re only paying the interest charges on your mortgage loan, the monthly payments are smaller.
- Valuable option for buy-to-let owners: Interest-only mortgages can be an excellent solution for buy-to-let landlords since they receive regular monthly payments from tenants to help pay back the capital.
- Opportunity to budget and invest savings: With an interest-only mortgage, you can potentially save on mortgage repayments and use the savings to invest or add value to your property.
Disadvantages of Interest-Only Mortgages
Interest-only mortgages also come with some drawbacks:
- Can be more expensive overall: Since the capital owed does not decrease over time and interest is paid on the entire amount, interest-only mortgages can be more expensive than repayment loans.
- Viewed as ‘high risk’ by banks and lenders: Due to the large lump-sum repayment at the end of the term, banks and lenders see interest-only mortgages as risky.
- Risk of shortfalls: The repayment vehicle you have in place may not perform as expected, leaving you unable to afford the lump sum and potentially needing to sell your home or find another way to pay off the balance.
What to Do If You Have an Interest-Only Mortgage
If you have an interest-only mortgage, it’s crucial to ensure you can repay the capital at the end of the term. Some options include:
Switch to a repayment mortgage: This will increase your monthly payments, but your mortgage will be repaid in full at the end of the term.
Invest in an investment plan: A financial adviser can suggest a suitable plan to help you save and pay off the capital at the end of the term.
Make lump-sum overpayments or set up regular overpayments: If your lender allows this, you can reduce the amount owed over time. Use a mortgage overpayment calculator to determine potential savings.
Remortgage for a better rate and switch to a repayment mortgage: You can extend the loan term to make monthly payments more affordable while still paying off the loan in full at the end of the term.
If you’re concerned about repaying the amount owed on an interest-only mortgage, take action as soon as possible—even if you’re years away from the mortgage end date. The longer you wait, the fewer options you’ll have. Seek financial advice promptly to avoid potential issues.
Interest-Only Mortgage Repayment Plans
Before lending money on an interest-only basis, mortgage lenders will require an approved repayment plan in place. Acceptable repayment plans vary among lenders but may include ISAs and stock market investments. Lenders are likely to conduct periodic checks to ensure your chosen repayment plan is on track to pay the required amount. It is important to note that few mortgage providers will accept future windfalls, such as inheritances or bonuses, as repayment plans.
Often customers would like to make use of the equity available in their home as a repayment plan, that is that they will have enough left to repay the mortgage and buy another home without a mortgage. As a result this approach comes with some additional criteria requirements:
- Maximum Loan to Value – Often lenders require you have at least 50% equity in the home.
- Minimum Equity – As well as a % equity value, they often require a £250k – £250k buffer in the property at completion
- Minimum income – Often lenders offering interest only mortgages require customers to have in excess of £75k per annum income.
Consequences of Failing to Repay an Interest-Only Mortgage
If you cannot repay your interest-only mortgage, you may face serious financial consequences. In such cases, it is crucial to seek professional advice and explore options such as switching to a repayment mortgage, making overpayments, or remortgaging. Failure to repay your mortgage may result in the repossession of your home, so addressing the issue promptly is essential.