Everything you need to know about interest-only mortgages

It is estimated that there are over 1.67m interest-only mortgages in the UK, but how exactly do they work, and what is the difference between interest-only and repayment mortgages? As a bridging loan broker, we understand the importance of knowing the difference between the two so that you can make an informed decision as to what is best for you, and so we’ve put together a guide explaining in full everything you need to know about interest-only mortgages.

 

What is an interest-only mortgage?

An interest-only mortgage as the name suggests is where you only pay interest to the mortgage lender on a monthly basis. That means that the capital you have accrued is not paid, just the interest. This will mean that whilst your monthly payments will be less than if you took out a repayment mortgage, you will still end up owing the original amount you borrowed. As a result, that will mean that it is your responsibility as a borrower to find another way in which you can repay the capital at the end of your mortgage term.  This is referred to by lenders as organising a separate ‘repayment vehicle’, and they will be looking for evidence from you of a repayment plan that demonstrates how you will pay the capital back. For many people who have taken out an interest-only mortgage, this will manifest itself in the form of selling other properties or paying a monthly amount separately into a stocks and shares ISA.

The history of interest-only mortgages

Prior to the 2008 financial crisis, interest-only mortgages were much more readily available. This is because, at this point, borrowers were able to make an application on an interest-only basis and be accepted for this type of mortgage without ever having shown the lenders how the debt would end up being repaid. However, after the credit crunch occurred, with financial markets collapsing and house prices plummeting across the UK, lenders realised that hundreds of thousands of people in the country would, in fact, struggle to be able to make repayments on their home loan.

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Since the 2008 financial crisis, the amount of interest-only mortgages being approved has declined.

Consequently, the proliferation of interest-only mortgages has diminished considerably in the last decade, and it is now quite difficult to be able to borrow money on an interest-only basis for mortgages. These days, not all lenders even provide the option of interest-only mortgages, with those that do still offer this kind of mortgage only doing so under strict eligibility criteria. Examples of this include:

  • A very high minimum income
  • A large deposit: depending on the lender the exact amount can vary, but it can be anything from at least 25%, with some mortgage providers requiring you to have a deposit equivalent of up to 50% of the property’s value
  • You will also need to show a robust repayment plan, and this doesn’t simply mean putting some money into a basic savings plan
  • It is worth remembering that is is very likely that your lender will carry out periodic checks on your chosen repayment plan, in order to sure that everything is on track and that you will still be able to pay back the required amount at the end of the term.

Interest-only mortgages vs repayment mortgages

Before deciding on which option is better for you, it is worth comparing the main differences between interest-only mortgages and repayment mortgages before making a final decision.

Interest-only mortgages

  • Each month you only pay back the interest charged by your lender
  • You will still owe the original amount at the end of the mortgage term
  • Monthly interest based on full amount original loaned to you. That means that it is possible you end up paying higher interest overall
  • It can be risky, as your ‘repayment vehicle’ may not pay dividends, as there is no guarantee that your investment will end up being enough to pay the mortgage in full when it comes to the end of the term
  • Interest-only mortgages do however give you the freedom to invest money that would have been spent paying off the capital on a mortgage elsewhere until the term ends. This means you could end up making a substantial profit if your investments do well.

Repayment mortgages

  • Each month you pay the interest charged by your lender, as well as part of the mortgage capital
  • Once you reach the end of your mortgage term, you will not need to pay any more as it has already been paid off
  • The monthly interest is calculated by looking at the amount you owe on your mortgage at that moment in time. That means that over the course of time, the interest will end up decreasing each month, unlike with interest-only mortgages
  • The better equity that you have, the greater the likelihood of receiving a far better mortgage rate.

What to do if you have an interest-only mortgage

It is vital that you carefully consider exactly how you will repay back the capital on an interest-only mortgage before the end of the term. There are a number of different ways you can do this:

  • You can decide to remortgage to a better remortgage rate
  • You have the option of deciding to switch your mortgage to a repayment mortgage. This will mean that whilst your overall mortgage monthly repayments will increase, you will have the home loan completely repaid by the end of the term
  • You could decide to make lump sum overpayments
  • You can set up regular overpayments on your mortgage. However, it is worth noting that not all lenders will allow you to do so, so you should always verify with your lender beforehand
  • Paying into an investment plan is another way in which you can pay off the capital on your mortgage. Consult a financial advisor for support and guidance as to the best ways to invest your money.