If you’re looking to take out a mortgage or invest in a property for the first time, you may be wondering about your mortgage repayment options. An interest-only mortgage can be an attractive option for borrowers who meet the eligibility criteria, as it offers lower monthly payments and financial flexibility.
In this guide, we’ll explore the benefits, risks and eligibility criteria for interest-only mortgages, so that you can start making an informed decision about your mortgage deal.
What is an Interest-Only Mortgage?
An interest-only mortgage is a type of loan where your monthly payments only go towards paying off the interest on the loan, not paying back the capital borrowed. This means that the amount you borrow does not decrease with your repayments over time. Instead, you’ll only pay interest for the duration of your term, with the remaining mortgage balance paid in full at the end.
For example, if your interest rate is 3%, monthly payments on a £200,000 loan could be around £500. However, you will still owe your lender the full £200,000 value of the initial loan at the end of the term, regardless of how long you’ve been making payments, and you’ll need a plan in place to repay this amount.
Lenders need proof that you can pay off the full amount before you take out an interest-only mortgage. This is known as a repayment vehicle and can come in the form of an investment, savings ISA or other assets.
Interest-only mortgages are particularly popular with certain types of borrowers. Buy-to-let investors often prefer them because the lower monthly payments provide more flexibility in managing rental income. They are also appealing to buyers who anticipate either a significant rise in their income before their mortgage term ends or, for example, a cash lump sum from inheritance or the sale of a property.
Why Choose an Interest-Only Mortgage?
Every borrower’s financial situation is different, and so are their reasons for choosing an interest-only mortgage. For those taking out an interest-only mortgage, the following factors are usually key considerations in the decision making process.
Lower Monthly Payments
The main benefit of an interest-only mortgage is lower monthly repayments. Since you’re only paying back the interest on your mortgage, your payments can be significantly lower than those on a repayment mortgage. By paying less back per month, you could free up money for other investments or expenses, such as home improvements.
Financial Flexibility
Some people opt for an interest-only mortgage because of the financial flexibility it offers. With an interest-only mortgage, borrowers can make lower payments initially and increase them if their financial situation improves near the end of their mortgage term. For example, if you know you’re due to inherit some money in the future, an interest-only mortgage gives you the option to buy the property now and pay off the price of your property once the term ends.
It is important to note, however, that future inheritance will not be considered as a repayment vehicle, and lenders will require an assured method of paying the mortgage balance at the end of the term, such as sale of property. Once the inheritance has been paid, this can be used to pay off the balance in place of the sale of the property.
Things to Consider
Before taking out an interest-only mortgage, it’s important to consider the risks involved:
Full Repayment of Capital
One of the main things to remember before taking out an interest-only mortgage is that you are liable to repay your loan amount in full at the end of the term. This means you’ll need enough money and a well-thought-out repayment plan, whether through savings, investments or selling the property. If you don’t have a solid plan in place, you risk losing your property at the end of your term.
Lack of Ownership
With a repayment mortgage, each monthly payment reduces the amount you owe, bringing you closer to owning the property. With an interest-only mortgage, you don’t reduce the principal debt, meaning that you do not build equity in the property during the mortgage term.
Who is Eligible?
An interest-only mortgage can be taken out on both residential and buy-to-let properties. However, the lending criteria tend to be less strict for those with substantial personal wealth or landlords purchasing a buy-to-let property as an investment.
Lenders typically require a clear and credible payment plan (such as selling the property or investments) to understand how you intend to repay the loan amount at the end of its term. It can be difficult to secure an interest-only mortgage without a robust payment plan, as lenders are becoming more cautious about approving this type of loan.
Homebuyers and buy-to-let investors will also require a deposit of at least 25% of the property value but lenders may require as much as 50% for residential buyers, as well as minimum income requirements. This can significantly limit who can purchase a property with an interest-only mortgage, as not only is the borrower required to pay back the loan in full, but put down a large deposit amount in the first place.
Comparison with Repayment Mortgages
When you take out a repayment mortgage, your monthly payments cover both interest and a portion of the capital, meaning the mortgage is guaranteed to be repaid by the end of its term.
When it comes to monthly payments, repayment mortgages may be more expensive, but they offer long-term security to homebuyers. Repayment mortgages tend to be more straightforward and better suited to homeowners looking to pay off their loan over time.
Interest-only mortgages, by contrast, have lower monthly costs but require a solid financial plan for the future, increasing the potential risk.
For example, while a £200,000 interest-only mortgage at a 3% interest rate would require a monthly repayment of £500, a repayment mortgage would require a monthly repayment of £1,200. However, you’ll generally pay less overall with a repayment mortgage because the total amount you owe decreases as you pay it back. With an interest-only mortgage, the amount you owe remains the same.
Mortgage Advice with Cooper Associates Mortgages
Choosing the right mortgage deal depends on your financial situation and future plans. Our expert mortgage advisers will work with you to evaluate the suitability of an interest-only mortgage and the risks and benefits involved. Get in touch for fee-free mortgage advice today.
