Interest Only Mortgages Explained

There are two main mortgages available in the UK: repayment mortgages and interest only mortgages. If you are in search of a mortgage, you might be wondering what type of mortgage is best for you.

The good news is the two mortgage types are normally used for specific situations. A residential mortgage where you buy a house to live in would ordinarily be a repayment mortgage. A Buy to Let mortgage where you buy a property to rent out will typically be an interest only mortgage.

However, there are circumstances where the two products cross over, so let’s explore interest only mortgages in detail.

What is an Interest Only Mortgage?

An interest only mortgage is a loan taken against a property where you only pay the interest. Traditionally when you take a loan, you will make repayments which include the amount you have borrowed and the interest charged by the lender.

With interest only mortgages, lenders allow you to pay the interest portion only because the loan is secured against your property. Securing the loan against a property reduces the risk to a lender compared to unsecured loans. In the event that you cannot make the interest payments, the lender still has the charge against the property to repossess, sell it and recoup the capital balance.

Interest only mortgages are not risk free though and lenders typically ask for a higher deposit amount and evidence that you have the funds to clear the capital at the end of the mortgage.

The Difference Between Interest Only and Repayment Mortgages

Interest only mortgages are cheaper on a side-by-side basis in the short-term because you only pay the interest each month. Repayment mortgages have both the interest and capital included in your monthly payment.

Having a cheaper mortgage payment is attractive to borrowers but there are disadvantages associated with interest only mortgages when compared to repayment mortgages.

Advantages of Interest Only Mortgages

The main advantage of an interest only mortgage is the reduced cost and the potential to claim the interest payments back as an allowable expense if you are using the mortgage for business – for example, letting the property out through a limited company. Below is a side-by-side comparison of the cost difference between an interest only mortgage and a residential mortgage.

You will notice from the example, the interest rate on an interest only mortgage is higher, this is because a typical interest only mortgage has a higher interest rate than a repayment mortgage.

Disadvantages of Interest Only Mortgages

There are four key disadvantages to interest only mortgages compared to residential mortgages:

• Interest rates tend to be higher than repayment mortgages./span>
• The deposit amount needed is often a lot higher with interest only mortgages.
• The total cost of the loan is far higher on an interest only mortgage.
• You will need to show lenders a way of repaying the outstanding capital at the end of the mortgage term

The last two points are important factors when deciding if an interest only mortgage is best for you.

Total Cost of the Mortgage

When you have a repayment mortgage you pay down a portion of capital each month which reduces the amount of the loan over time. As the capital reduces the interest chargeable on the capital also reduces.

For example, if you have a mortgage with £200,000 in year one, you are paying the full amount of interest on the £200,000. By year 15, you might have reduced the loan to £100,000. The interest on £200,000 and £100,000 is significantly different when you look at your monthly cost.

In comparison, on an interest only mortgage, you will still be paying the interest on the full £200,000 throughout the mortgage term.

What Happens at the End of the Term of an Interest Only Mortgage?

When your interest only mortgage ends, you will need to repay the outstanding capital to the lender in a single payment. This is similar to balloon payments on car finance agreements where there is a balance outstanding to be paid in full at the end of the loan. Mortgage lenders will want you to show a clear way of repaying this money when you make your interest only mortgage application.

Solutions for an Expiring Interest Only Mortgage

The repayment of the capital is known in the mortgage industry as a repayment vehicle. Repayment vehicles can come in many forms and the key factor is being able to demonstrate to lenders that you will have the funds available to repay the capital.

Examples of repayment vehicles are:

• Savings
• Investment accounts
• Selling the property
• Sale of other property or assets

This list is not exhaustive and if you have other methods to repay an interest only mortgage you should discuss it with your mortgage broker who will be able to tell you if it is suitable for the lender.

You may have heard about endowment policies linked to interest only mortgages, but these are generally not accepted now by lenders. Historically it was common for people to take an endowment policy alongside a mortgage with the view to repay the capital at the end of the mortgage.

Unfortunately, endowment policies rarely achieved the target figure and borrowers found themselves unable to repay the mortgages. As a result, the industry has tightened regulation of interest only mortgages and lenders will want a more concrete repayment vehicle.

How a Mortgage Broker Can Help

Interest only mortgages are a useful product in a wide range of circumstances and could present you with a better opportunity than a repayment mortgage. Whether a repayment mortgage or interest only mortgage is suitable will be dictated by your personal circumstances and goals.

A mortgage broker will be able to evaluate your current financial situation and assess your mortgage goals to provide detailed expert advice. Looking to discuss an interest only mortgage further? Request a callback today by filling out our contact form.