Interest Only Mortgages – What You Need to Know

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Decades ago, you would be able to buy a property and use an interest only mortgage with most lenders. Typically, these mortgages had endowment policies alongside them. The aim was for borrowers to repay the interest each month and at the end of the mortgage term, the endowment policy would repay the capital. Unfortunately, endowment policies frequently underperformed, with most failing to cover even a small portion of the remaining capital.

Lenders subsequently shied away from interest only mortgages for residential purchases. However, in recent years, lenders have introduced more interest only mortgages. Let’s find out about interest only mortgages and what you need to get one.

What is An Interest Only Mortgage?

An interest only mortgage allows you to borrow the full capital and interest amount required to buy a property and only pay the interest on the loan. The capital remains throughout the mortgage and unless you make overpayments on your mortgage you will have the full capital outstanding at the end of the mortgage term.

This is like car finance agreements that allow you to pay the interest on the loan and have a balloon payment at the end of the loan term. When you have a capital repayment mortgage, your monthly mortgage payments will be higher compared to interest only mortgages. With a capital repayment mortgage, your monthly payment incorporates both capital and interest. Compared to an interest only mortgage, where you only pay the interest on the loan each month.

How Do Interest Only Mortgages Work?

Paying the interest each month allows you to keep your mortgage costs to a minimum. You will need to have a repayment vehicle alongside your mortgage. Each lender specifies the type of repayment vehicle they deem acceptable.

What is a Repayment Vehicle?

A repayment vehicle is a method to pay the outstanding balance (capital) at the end of an interest only mortgage term. An endowment policy was a type of repayment vehicle intended to repay the capital when the mortgage term ends.

Today you are unlikely to be able to use an endowment policy as these products perform poorly and lenders are reluctant to accept them. There are other repayment vehicles that are typically used by lenders on interest only mortgages:

  • Pension – if you have a significant pension pot you could use this to repay the capital
  • Selling the Property
  • Savings
  • Investments

Lenders are fairly flexible about the type of repayment vehicle you use; however, you will need to demonstrate that your chosen method will have the capital to repay the mortgage. For example, if you aim to use investments to repay the mortgage you will need to show a lender that your investments can realistically achieve the amount of capital required.

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Eligibility Criteria

Interest only mortgages are riskier for lenders compared to capital repayment mortgages. This is because there is always the chance your repayment vehicle fails and the property itself isn’t valuable enough to recover the amount of capital borrowed. To counter this, lenders will normally insist on a much higher deposit requirement. Most interest only mortgages have a minimum deposit requirement of 25%.

Lenders aim these products at high-net-worth individuals rather than those struggling financially and if you are struggling with your mortgage currently, there may be more suitable options than trying to obtain an interest only mortgage.

You should contact a mortgage broker in the first instance to ascertain what options are available to you and find out if an interest only mortgage is the right mortgage for you. If you have a deposit or existing equity that meets the lenders’ threshold you will also need to provide evidence and documentation for your repayment vehicle.

This can include:

  • Pension statements
  • Savings account statements
  • Investment statements

Because repayment vehicles are scrutinised heavily by lenders, they may request a lot of additional information from you. A lender will want to ensure that your repayment vehicle has a high probability of covering the capital on the mortgage.

Finally, you will also need to pass the lender’s credit score requirements for an interest only mortgage in the same way as a traditional mortgage.

Pros of Interest Only Mortgages

The only real positive of an interest only mortgage is the lower monthly payment. Buy to let landlords like these products as they can make profit by charging rent higher than the monthly interest payment and can sell a property to repay the capital if required.

On a residential basis, this type of mortgage is significantly riskier, and it is also more expensive compared to a capital repayment mortgage.

Cons of Interest Only Mortgages

If you have a residential interest only mortgage, you will need to make sure your repayment vehicle covers the cost of the capital repayment. Failing to do so may result in you losing your home. This is a significant downside of interest only mortgages for residential purposes as you are risking the security of having a roof over your head.

At the end of a mortgage term, you might be too old to apply for another mortgage and it could leave you with little to show for your efforts paying the mortgage over the years. Interest only mortgages are also likely to be MORE EXPENSIVE than capital repayment mortgages overall. This is because with a capital repayment mortgage you are paying the capital each month as well as the interest. Over time your capital reduces, and the value of the interest payment drops in line with this reduction.

To put this in clearer terms, an interest only mortgage in year 20 will still have the original capital balance – let’s say £200,000. A repayment mortgage will have dropped over time and by year 20 you might owe £20,000. 5% (interest) of £200,000 is significantly more than 5% of £20,000. This makes interest only mortgages poorer value for money in total cost.

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How to Get an Interest Only Mortgage

If repaying the capital each month is out of the question or it is financially sensible to pay interest only you should discuss your goals with a mortgage broker.

Boon Brokers is a UK-based Whole of Market Mortgage, Insurance and Equity Release brokerage, with access to lenders who have flexible repayment vehicle options and provide interest only mortgage advice. Contact us to arrange your free no obligation consultation today.

Gerard BoonB.A. (Hons), CeMAP, CeRER

Gerard is a co-founder and partner of Boon Brokers. Having studied many areas of financial services at the University of Leeds, and following completion of his CeMAP and CeRER qualifications, Gerard has acquired a vast knowledge of the mortgage, insurance and equity release industry.