Advertisement
UK markets close in 7 hours 5 minutes
  • FTSE 100

    7,958.50
    +26.52 (+0.33%)
     
  • FTSE 250

    19,797.37
    -13.29 (-0.07%)
     
  • AIM

    741.81
    -0.30 (-0.04%)
     
  • GBP/EUR

    1.1677
    +0.0008 (+0.07%)
     
  • GBP/USD

    1.2588
    -0.0050 (-0.40%)
     
  • Bitcoin GBP

    56,114.07
    +648.65 (+1.17%)
     
  • CMC Crypto 200

    885.54
    0.00 (0.00%)
     
  • S&P 500

    5,248.49
    +44.91 (+0.86%)
     
  • DOW

    39,760.08
    +477.75 (+1.22%)
     
  • CRUDE OIL

    81.55
    +0.20 (+0.25%)
     
  • GOLD FUTURES

    2,214.80
    +2.10 (+0.09%)
     
  • NIKKEI 225

    40,168.07
    -594.66 (-1.46%)
     
  • HANG SENG

    16,541.42
    +148.58 (+0.91%)
     
  • DAX

    18,501.29
    +24.20 (+0.13%)
     
  • CAC 40

    8,243.47
    +38.66 (+0.47%)
     

What is an interest-only mortgage?

 (Pexels)
(Pexels)

Most of us are unable to put down all the money we need upfront when we’re buying a property. The answer is to turn to a bank or building society for a home loan, otherwise known as a mortgage.

Mortgages come in different guises. One of these is the interest-only option which has both advantages and disadvantages for potential homebuyers. Here’s an explanation of what they are, how they work, and why you might consider getting one.

What is an interest-only mortgage?

An interest-only mortgage is a loan you take out from a lender to buy a property. As the name suggests, your monthly payments only cover the interest that’s outstanding on the loan. In effect, they only make up part of the overall repayment pie.

ADVERTISEMENT

This differs markedly from the more common home loan alternative known as the repayment mortgage. With the latter your monthly repayments go towards paying off the interest on the loan, as well as whittling down the capital that’s outstanding on the arrangement.

With an interest-only mortgage, you pay less every month than with a standard repayment vehicle. However, and this is the crucial part, at the end of the mortgage term you will still owe the original amount that you borrowed.

As such, if you take out an interest-only mortgage you also need a plan to pay off the capital when the mortgage term ends.

How do they work?

The process is similar to applying for any other mortgage. The lender will run a valuation on the property and will want to know you have the financial means to keep up with repayments.

Once approved, the interest-only mortgage amount plus your deposit will allow you to purchase the property.

For example, if the purchase price was £300,000 and you put down a deposit of £60,000 (or 20%), your mortgage requirement would be £240,000.

If you took out a 25-year interest-only mortgage at an interest rate of 4%, every year you’d have to pay 4% of £240,000, which is £9,600 – or £800 a month.

Crucially, the £800 only covers interest payments, so you still owe £240,000 when the mortgage term ends.

Based on current figures, the typical monthly outlay by comparison for a standard repayment mortgage in this example would be around £1,300. A substantially greater sum, but don’t forget you’ll have cleared the debt by the end of the mortgage term.

An interest-only home loan requires you to make provision to pay off the outstanding capital by establishing and building up a ‘repayment vehicle’.

For example, you might decide to set up an Individual Savings Account invested in the stock market to run over the mortgage term aimed at paying off the outstanding sum. Or you could rely on other assets. Otherwise, you’ll eventually have to sell the property to pay back what you owe.

Who offers interest-only mortgages?

Wind the clock back to a pre-credit crunch world of 2008 and interest-only mortgages were common. These days, lenders are far more cautious about offering them to potential homebuyers.

Residential interest-only mortgages are still available from banks and building societies to those who have large deposits. For example, where customers only need to borrow up to 50% of a property’s value. The numbers mean interest-only mortgages are often out of the reach of first-time buyers,

Buy-to-let property owners, on the other hand, might get more joy. Especially if they can show that the rental return on a property will significantly cover any costs.

Right for you?

It’s easy to see the attraction. An interest-only mortgage sounds good in theory because you pay less in mortgage repayments every month.

If you’re confident that property prices will rise, they might also seem a good option because you’ll benefit from any increase in value to your home.

However, if house prices were to fall, you could end up financially worse off. You could even find yourself in a position of negative equity if the property’s value drops below what you owe. This is where you owe more than the open market value of the property.

Tread carefully

Buyers, therefore, should tread carefully with interest-only home loans. The property will still need to be paid for at some point and it’s worth considering whether any investment or savings provision you make to eventually pay off the capital outweigh making monthly repayments on the existing loan.

You will also probably have to remortgage at a future date. An interest-only deal might provide a low initial rate. But when it expires, if your arrangement reverts to a higher interest rate, then you might find it’s not easy to switch to another interest-only deal.

How do you get an interest-only mortgage?

You can go through a comparison website to compare rates on interest-only mortgages, or speak to your current bank to see if it can offer a competitive deal.

Another option is to get in touch with a mortgage broker. The advantage here is that some banks reserve their best interest-only deals exclusively for brokers (or ‘intermediaries’) to service their clients. Some brokers will charge a fee, whereas others work from commission.

The key point is that it’s worth doing your research before making a decision as you could potentially save thousands of pounds in the process. You should also factor in the overall cost of any deal and take into account any extras you end up being charged. An eye-catchingly low interest rate could be offset by a high initial fee tacked on to the home loan in question, for example.

How do you qualify for one?

You’ll need to meet the lender’s criteria, such as showing proof of income, and then your lender will take you through the steps.

If you’re not quite ready to apply, but want to know how much you could borrow on an interest-only mortgage, you could look at getting an agreement in principle from a lender.

This is an assurance, but not a guarantee, that it will lend to you at the stated terms. It’s a useful tool when you are putting forward an offer on a property.

What if you can’t repay an interest-only mortgage?

As with any mortgage, if you are struggling to make repayments you should speak to your lender and explain the situation. It might be able to offer you a payment holiday, for example.

Never bury your head in the sand and start missing repayments, though. Not only will this put you further in debt but it will damage your credit score, which will make borrowing more difficult in the future.

Debt charities such as Citizens Advice and StepChange can provide guidance and support. Ultimately, a mortgage is a secured loan which means if you fail to keep up with your repayments your home could be repossessed and sold to cover the debt.