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Interest-only mortgages - Everything you need to know

Posted 4 September 2017

Wondering what an interest-only mortgage is or what the advantage are? Here is your guide to interest-only mortgages.

According to research from Citizens Advice, there are around 3.3m people in the UK with an interest-only mortgage.

These types of loan were hugely popular in the 1990s and 2000s although they have become far less common since the global financial crisis.

So, what is an interest-only mortgage? How do they work? And what do you need to know if you have one? Our guide explains all.

What is an interest-only mortgage?

Under the terms of an interest-only mortgage, your monthly mortgage payment is based on the loan interest, while the balance of the mortgage never reduces.

So, if you take a £200,000 interest-only mortgage over 25 years, you’ll still owe the full £200,000 at the end of the term. Your payments in the meantime will simply consist of the interest charged on the borrowing.

How does an interest-only mortgage work? Interest-only mortgages explained

With an interest-only mortgage, you only pay interest to your lender each month. The intention is that over the term of your mortgage you build up a lump sum in order that you can pay off the loan at the end.

Rather than paying off the money you’ve borrowed every month as part of your payment, you have to set up a separate ‘repayment vehicle’ in order to generate enough money to repay the capital. This can be an investment such as stocks and shares, an ISA, a pension, or another type of savings vehicle such as an endowment policy.

Interest-only vs repayment mortgages – differences

With an interest-only mortgage your monthly payment only consists of interest. At the end of the mortgage term, you still owe the original amount that you borrowed.

This is different to a repayment mortgage where you pay back some of what you borrowed every month, as well as interest. By the time the mortgage term finishes, you've repaid your loan in full.

Read our article on what type of mortgage to choose for more information on the different types of mortgages available.

Advantages and disadvantages of an interest-only mortgage

One of the main reasons to take out an interest-only mortgage is because the monthly repayments are lower than an equivalent repayment loan. As you’re only paying the interest the payments are cheaper, although you should remember that you’re not paying back anything that you borrow.

If you’re looking to make infrequent overpayments to your mortgage, then interest-only might be a good option. You can repay lump sums when you want to while keeping your monthly repayment as low as possible for the times when you need to pay less.

You should remember that an interest-only mortgage is risky as there is no guarantee that your repayment vehicle will be enough to repay the loan at the end of the term. If it isn’t, you may face a shortfall when you come to repay your mortgage.

In addition, you also pay more interest overall if you take an interest-only mortgage. This is because you’re paying interest on the entire sum that you borrow for the whole term. This is different to a repayment mortgage where you are gradually paying off the balance and the interest is only charged on the amount that you still owe every month.

When is an interest-only mortgage a good idea?

If you’re looking to reduce your repayments as low as possible – perhaps because you want to get onto the property ladder – then an interest-only mortgage might be right for you. You should regularly review your arrangements and convert to a repayment mortgage as soon as you can.

If you have savings or investments that are sufficient to repay the loan, then you may also consider interest-only. Perhaps you have a second property that you’re planning to sell in order to repay the mortgage, or investments that you know will be sufficient?

Many buy-to-let borrowers also choose an interest-only mortgage. As well as keeping their repayments down, there can be tax advantages for doing this.

What if I can’t pay off my interest-only mortgage?

The main risk with an interest-only mortgage is that you get to the end of the term and you don’t have enough money to repay the money that you owe.

Recent research has found that thousands of borrowers may be in this position. A study by financial mutual OneFamily has found that over a quarter of interest-only mortgage holders could struggle in paying off an interest-only mortgage – equivalent to around 890,000 borrowers.

One in ten respondents said that they have no plan in place to repay their mortgage. This follows 2015 Citizens Advice research which found that 430,000 people “have not even thought about how they will repay the capital” to their home loan.

If you find yourself in this position, you should speak to your lender. They may allow you to repay part of your mortgage with the cash you have available. Or, they may let you convert the remainder to a repayment basis over an extended term.

You may also have to consider alternative options to repay what you owe. This may include:

  • Downsizing and moving to a cheaper property
  • Repaying capital from other sources, for example your pension
  • Remortgaging to a lower rate and overpaying

Can I extend my interest-only mortgage?

You should speak to your lender as the end of your mortgage term approaches.

You may be able to extend your loan, although this could depend on factors such as your age, your income and your outgoings.

What happens at the end of an interest-only mortgage?

Paying off an interest-only mortgage is a contractual obligation at the end of your mortgage term.

The Financial Conduct Authority says: “We recognise that customers remain responsible for repaying their mortgages, that repayment of the capital at the end of term is a contractual requirement, and that firms are not obliged to offer options at maturity.”

However, borrowers are also required to treat their customers fairly. They should work with you to find a solution.

How to pay off an interest-only mortgage early

There are lots of ways that you can repay your mortgage early. You can use investments such as endowment policies, ISAs or shares to repay your loan, or you might want to use a lump sum from your pension.

The OneFamily research also found that 24% of mortgage holders plan to sell their home and move to a cheaper property in order to pay off their debt.

Can you overpay on an interest-only mortgage?

Making overpayments is a good way to clear your interest-only mortgage. There are two ways that you can make overpayments:

  • On a monthly basis if you have a flexible mortgage where the interest is calculated daily
  • On a 'lump-sum' basis once you have saved up your lender's minimum capital repayment (typically £500 or £1,000)

If you’re considering paying a lump sum to your mortgage, check that you won’t be penalised for doing so. If you’re on a special fixed or variable interest-only rate, you may only be able to repay part of your outstanding mortgage balance (typically 10%) without incurring an ‘early repayment charge’.

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