Interest-only mortgages are not as prevalent today as they were before the credit crunch, and have been the subject of mis-selling scandals of the past. But for some borrowers on the hunt for the best mortgage rates, this kind of mortgage offers flexibility and the opportunity to better manage their money.
What is an interest-only mortgage?
As the name suggests, borrowers who take out an interest-only mortgage only pay the interest that accrues on the debt each month. They make no payment towards the actual debt itself.
As a result, at the end of your mortgage term you will not have repaid any of the debt. The balance you owe remains the same.
Once you reach the end of your mortgage term, you are then required to pay off the sum you initially borrowed.
Borrowers with a repayment remortgage pay towards both the interest and their outstanding debt each month. As a result, when they reach the end of their mortgage term, there is nothing left to pay; the debt will have been repaid in its entirety.
What are retirement interest-only (RIO) mortgages?
RIO mortgages are a relatively new form of interest-only mortgage, and as the name suggests, are aimed at older borrowers.
As you get older, it can prove tougher to get a standard mortgage. With some lenders insisting that the entire mortgage is paid off by the time you reach retirement. They are basically concerned that once you give up work, you won’t be able to make the necessary repayments.
However, there may be times when you still need to borrow as you approach retirement. In this instance a RIO mortgage could be the answer.
With a RIO mortgage, as with a regular interest-only mortgage, you make monthly payments which cover the interest being charged on the sum you have borrowed. Usually the capital is repaid when you sell the property, move into residential care, or die.
How do interest-only mortgages work?
Let’s say that you apply for an interest-only mortgage of £200,000, at an interest rate of 3%, over a 25 year term. Each month you will pay £500.
Then, at the end of the 25 year term, you will need to repay the £200,000 which you initially borrowed, and which is still outstanding.
Unlike a capital repayment mortgage, stretching the mortgage term does not lower your monthly payments.
For example, if you choose a 30 year mortgage term rather than a 25 year mortgage term, you’ll still have to pay £500 a month in interest. The longer term means you will have five more years before you must repay the initial £200,000 debt, but equally you will also be paying interest on that debt for an additional five years.
How do I get an interest-only mortgage?
Mortgage lenders do not offer separate products which are only available on an interest-only basis. Instead, when you apply for the home loan, you’ll be able to tell them that you want to take it out as an interest-only mortgage rather than a repayment mortgage.
However, it’s important to note that lenders employ different rules when assessing an interest-only mortgage application compared with a capital repayment mortgage. This can make it tougher to get one than a regular repayment mortgage. This may mean that it’s not suitable as a first time buyer mortgage.
For example, you are likely to need to put down a larger deposit ‒ often of at least 25% ‒ in order to secure an interest-only mortgage. By comparison, you can get a capital repayment mortgage with a deposit of as little as 5%.
Other examples of potentially tougher criteria on interest-only mortgages include:
- Age restriction at the end of your mortgage term, e.g. 70 years old
- A higher minimum of salary, sometimes of between £50,000 and £100,000
- Lower loans offered in relation to earnings
Perhaps the most crucial criteria though is the requirement to have a credible way of repaying that initial loan when you reach the end of your mortgage term, known as the ‘repayment vehicle’. Different lenders will accept different forms of repayment vehicle, such as the sale of a property, proceeds from investments, or a lump sum from your pension.
It is vital to have a repayment plan in place with an interest-only mortgage. If you do not have the means to repay the mortgage in one lump sum at the end of the term, the lender is within its rights to repossess your home to repay the debt.
Has it got harder to get an interest-only mortgage?
Before the global financial crisis in 2008, mortgage rules were much slacker.
Borrowers who might not ordinarily be able to afford a capital repayment mortgage were able to buy through interest-only mortgages, while lenders often did not ask what the repayment plan was.
If there was no plan, the borrower could simply state they would sell the property at the end of the mortgage term.
“Times have certainly changed,” says Colin Chapman, director of mortgage broker Genesis Financial Services. “Interest only is now the preserve of the wealthy who have lots of equity in their homes and high salaries. Only credible repayment plans such as the sale of investment properties, a pension pay out if your savings are big enough or bonuses if you have a job such as city trader will be accepted.”
Selling your home to repay the mortgage is still allowed, but lenders may stipulate you must have between £200,000 and £300,000 equity in your property before they grant the mortgage.
The thinking goes that by the time your mortgage term expires, your property will have risen in value enough to allow you to sell up, clear your mortgage debt and still have enough money left over to downsize.
Interest-only mortgages vs repayment mortgages
Before you decide whether to take out an interest-only mortgage or capital repayment mortgage, it’s useful to compare how much each of them costs to pay back overall.
A borrower who takes out a £200,000 mortgage over 25 years on a rate of 2.5%* would pay £897.23 a month for a capital repayment mortgage or £416.67 a month for an interest only mortgage
As you can see, on a monthly basis, the interest-only mortgage would mean much lower repayments. However, it’s important to bear in mind that as the debt isn’t going down over time, you will continue to be charged interest on the full amount, for the entire term of the mortgage.
As a result, over 25 years, the total interest payable would be £69,169 on a capital repayment mortgage. But £125,000 on an interest-only mortgage. In other words, an interest-only mortgage will mean paying almost twice as much in interest overall, in return for those smaller monthly repayments.
Are interest-only mortgages the same as endowment mortgages?
You may have heard of endowment mortgages, which were a type of interest-only mortgage that was popular in the 1980s and 1990s.
Banks and building societies sold interest-only mortgages alongside policies called endowments. These were a mixture of an investment plan and a life insurance policy. Your monthly mortgage payment was made up of part interest on your loan and part premium for your endowment.
The mortgage company invested the premium on your behalf with the aim of building up a pot of money that was at least the size of your mortgage debt so you could clear the balance at the end of the term. There was also the promise of spare cash left over.
In many cases, however, the investments failed to deliver, leaving homeowners with a shortfall that they had to pay themselves.
Endowment mortgages are no longer available, but borrowers can take out their own investment plan to repay the debt at the end of the term.
Pros and cons of an interest-only mortgage
There are some potentially powerful pros to opting for an interest-only mortgage when buying a house.
- Lower monthly payments, which can make budgeting easier
- Money saved by not repaying the debt every month could be put into an investment which has the potential to increase in value higher than your mortgage debt.
However, there are some important downsides to an interest-only mortgage, when compared with a capital repayment mortgage.
- You will pay back more interest over the term of the mortgage
- You’ll need to have a larger deposit
- There is a risk that your repayment plan will not deliver enough cash to clear your mortgage at the end of the term which means you’ll have to sell the house, find another mortgage or face repossession.
Are interest-only mortgages a good idea?
Ultimately whether an interest-only mortgage is a good idea for you will come down to your own circumstances. Make sure you speak to your mortgage provider or a mortgage broker.
You need to be disciplined to make an interest-only mortgage work. While you have lower monthly mortgage payments, you will need to put money aside in other ways to help cover the cost of repaying that capital at the end of your mortgage term.
It also pays to be flexible. You might start out with an interest-only mortgage, intending to pay off the debt at the end of the term with the proceeds from investments in another asset, like stocks and shares.
But if those investments struggle, and are not worth enough to pay off the mortgage debt, then you will need to consider other options, which may include selling the property.
It’s worth remembering that while your monthly repayment with an interest-only mortgage solely covers the interest on your debt, you will be able to make additional payments towards repaying the actual capital debt too. This could be on a one-off basis, if you’re feeling particularly flush one month, or on a regular basis. This means that when you reach the end of your mortgage term, there is less debt still left to pay off.
With thanks to John Fitzsimons for his contributions to this article
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