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Interest-Only Mortgage

What is an interest-only mortgage?

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What is an interest-only mortgage?

With an interest-only mortgage, your monthly payment covers only the interest charges on your loan, not any of the original capital borrowed. This means your payments will be less than on a repayment mortgage.

However, at the end of the term, you’ll still owe the original amount you borrowed from the lender, which you will usually need to pay as one lump sum. So, it is wise to determine from the outset how you plan to cover the total loan cost at the end of your term.

Bear in mind that banks and mortgage providers are unlikely to put people in an uncomfortable situation, as they want to make sure you’re able to pay back what you owe them. For this reason, interest-only mortgages are not the most common form of mortgage loans.

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The difference between interest-only and repayment mortgages

There are two ways to repay your mortgage:

  • Repayment

  • Interest-only

With a repayment mortgage, you pay back a small part of the loan and the interest each month. Assuming you make all your payments, you’re guaranteed to pay off the whole loan at the end of the term.

With an interest-only mortgage, you only pay the interest on the loan. At the end of the term, you’ll still owe the original amount you borrowed.

The main advantage of paying a mortgage on an interest-only basis is that your monthly payments will be much cheaper.

Let’s say you borrow £200,000 on an interest-only basis, over 25 years, at an interest rate of 3%. In this scenario, if you repay the mortgage on an interest-only basis, you’d pay £500 a month. But if you instead decide to repay the mortgage on a repayment basis, you’d pay £948 a month. This would make your monthly instalments way more substantial.

An interest-only mortgage can make a mortgage more affordable. But in this case it would mean that, in 25 years’ time, you’d still owe the lender £200,000. If you paid the mortgage on a repayment basis, you’d owe the lender nothing and own the property outright at the end of the term.

The history of interest-only mortgages

Interest-only lending soared ahead of the 2008 financial crisis. Customers were able to borrow on an interest-only basis without showing lenders how the debt would be repaid. After the credit crunch struck, it emerged that hundreds of thousands of interest-only customers would struggle to pay off their home loan later on.

For this reason, it’s now very difficult to borrow on an interest-only basis. In fact, it is fair to say that not all lenders offer interest-only mortgages. But those that do will have strict criteria, such as a decent deposit and an approved repayment vehicle in place. This will act as some sort of security to pay off the capital at the end of the term.

The one exception is buy-to-let. Many landlords pay their mortgages on an interest-only basis and lenders generally accept this.

Either way, if you can’t repay the amount you borrow at the end of the term, you’ll need to take out a new mortgage or sell the property to pay off your mortgage.

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What are the advantages of an interest-only mortgage?

It is fair to say that taking out an interest-only mortgage can have its array of positives. Here are some of its most prominent advantages:

  • Tick

    More affordable monthly payments

    As mentioned, one the most evident benefits of an interest-only mortgage is that it comes with smaller monthly instalments. This is because, in effect, you’re only paying the interest charges on your mortgage loan

  • Tick

    Valuable option for buy-to-let owners

    An interest-only mortgage is often seen as a good solution for buy-to-let landlords. In fact, as they receive regular monthly payments from their tenants, landlords can put aside their profits to pay back the full capital when the time comes

  • Tick

    You can budget and invest your savings

    Another advantage is that, with an interest-only mortgage, you have the opportunity to budget and save on your mortgage repayments. You could use what you’re saving to add value to your new property

What are the disadvantages of an interest-only mortgage?

As with everything, an interest-only mortgage may have its own set of disadvantages. If you’re thinking about getting this type of mortgage loan, you may want to consider these aspects too:

  • Cross

    Can be more expensive overall

    Bear in mind that, with an interest-only mortgage, the capital you owe does not decrease over time. Plus, you’ll have to pay interest on the whole amount too. This means that, overall, an interest-only mortgage is likely to be more expensive than a repayment loan

  • Cross

    Banks and lenders view it as 'high risk'

    Because an interest-only mortgage requires you to pay one large lump-sum at the end of your term, banks and lenders see it as a risky type of mortgage loan. This is why you may be asked to invest in ISAs and stock markets

  • Cross

    Risk of shortfalls

    There’s a chance that the repayment vehicle you have in place won’t perform as well as you hoped, leaving you unable to afford the lump sum. In this case, you may need 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 important to know you’ll be able to repay the capital at the end of the term. There are several options to ensure this happens:

  • Switch your mortgage to a repayment mortgage. This will mean your monthly payment will increase, but your mortgage will be repaid in full at the end of the term

  • Pay into an investment plan which can be used to pay off the capital at the end of the term. A financial adviser will be able to suggest a suitable plan

  • Make lump-sum overpayments or set up regular overpayments on your mortgage (if your lender allows this). Our mortgage overpayment calculator can help you work out how much you could save

  • Remortgage to a better mortgage rate, switch to a repayment mortgage, and repay the loan over a longer term to make monthly payments more affordable

If you’re worried about repaying the amount owed on an interest-only mortgage, you should take action now, even if you’re several years away from the mortgage end date. The longer you leave it, the fewer options you’ll have. So, it’s important to seek financial advice as soon as possible.

Your home may be repossessed if you do not keep up repayments on your mortgage.

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Before lending money on an interest-only basis, your mortgage lender will want to see that you have an approved repayment plan in place. Acceptable repayment plans vary from lender to lender but may include ISAs and stock market investments. Your lender is likely to make periodic checks that your chosen repayment plan is on track to pay the required amount.

Previously, lenders would allow borrowers to rely on the possibility of a future windfall, such as an inheritance or bonus. However, very few mortgage providers will accept these now.

Your first port of call may be to get in touch with your mortgage provider. If you’re struggling – or will struggle – to pay back you debt, letting your lender know and finding a solution together could be a safe bet. For instance, they may allow you to extend the end term of your loan, giving you more time to put aside money to pay off the balance.

If you’re currently on a high-rate mortgage, you may even want to consider remortgaging and sourcing a cheaper, more convenient deal.

Another option, although not the most appealing, could be to sell your property. With any luck, if your house will have increased in value over time, meaning that you will be able to cover the costs of your debt. Not only that, but you may also have some cash left that you could use towards your new home.