An interest only mortgage is a type of mortgage where the borrower only pays the interest on the loan each month and does not reduce the actual value of the loan on the property. This usually results in cheaper monthly payments, however it means that at the end of the mortgage period the borrower still owes the full amount borrowed. For example, if a property costs £120,000 and a £20,000 deposit was paid, after the interest only mortgage comes to an end the borrower will still need to pay back the £100,000 loan.
An interest only mortgage should only be considered by those who have a plan in place to repay the loan when the term of the mortgage ends. There are a number of ways you can make sure you have the funds needed to repay the loan, one of the most common being through investments, such as ISAs and stocks and shares, which you plan to add to throughout the mortgage period to ensure you’ll have enough to pay off the loan.
However, bear in mind that if you plan to regularly pay into an investment during the term of the mortgage then your outgoings may be similar to those of a repayment mortgage, where your monthly investment could have become your monthly repayment instead. The only difference is that with an interest only mortgage you are making two separate payments – putting money into your investments alongside paying your mortgage interest – rather than paying off the mortgage and interest within one payment. It’s also worth noting that, with investments, there’s no guarantee – you can plan for growth but the eventual performance of your funds may be less than you were expecting, and even if you saved in cash, interest rates may change and you could find your savings are unable to even beat inflation.
Another alternative is to hope that the value of the property increases over the mortgage term, so that once you get to retirement age you will be able to sell your home and the money made will be enough to pay off the loan and enable you to buy a smaller property in which to live. This is a risky option as the property market is not as predictable as it once was and your property may not gain the amount needed. You may not have additional money spare for a new property and you could find yourself in negative equity at the end of the mortgage term.
It is important to remember that, even with an interest only mortgage, it is vital that you are able to make the repayments each month, as if not you could lose your home. A mortgage provider will assess your income and outgoings thoroughly to ensure that you will be able to meet the monthly repayments both from an affordability perspective and to check on your credit rating. An interest only mortgage is not in itself a solution to getting a mortgage with a poor credit rating; the provider will want to know how you plan to repay the loan at the end of the mortgage period.
Affordability is a key factor in determining whether or not an interest only mortgage is right for you – if you have any doubts that you will not be able to meet the monthly repayments, or if you don’t think you’ll have enough money to pay off the loan at the end of the mortgage, then you should seriously reconsider getting an interest only mortgage. An interest only mortgage should not be used to purchase a home that is of a higher value than you can afford to buy; if you aim to do this you will likely be rejected, and if accepted you may find yourself in financial difficulty when it comes to repaying the loan at the end of the term.
If you already have an interest only mortgage and you are at the end of the term but are unable to repay the loan amount, speak to your lender – you may have the choice of remortgaging with another interest only mortgage or switching to a repayment mortgage. Most mortgage providers will prefer you to have a repayment mortgage, especially if you are not able to show a satisfactory way to repay the loan amount at the end of the term. They may include options such as a repayment mortgage with a longer term to help make monthly payments more affordable and reduce the risk of you not paying off your mortgage in full.
If you reach retirement and still need to pay off your interest only mortgage, you could choose to switch to a retirement interest only mortgage. This mortgage works in much the same way as a standard interest only mortgage in that you only pay the mortgage interest each month, however the difference is that the loan will only be paid off when you die, move into long-term care or sell your home. This option would mean that any inheritance you pass on to loved ones will be reduced as the mortgage provider is entitled to the value of the loan when your property is sold, with the inheritance being the money left over, if any, once the loan is repaid.
Find out more about how retirement interest only mortgages work in our short guide.
If you’re thinking of taking out an interest only mortgage, you should make sure you have an investment portfolio that will earn the returns needed to repay the mortgage when it ends. This type of portfolio, such as investing in stocks and shares, does come with an element of risk.
Disclaimer: This information is intended solely to provide guidance and is not financial advice. Moneyfacts will not be liable for any loss arising from your use or reliance on this information. If you are in any doubt, Moneyfacts recommends you obtain independent financial advice.