There are two main types of mortgages; interest-only mortgages and repayment mortgages. There are sub-categories within those two broad categories, but all mortgage types will be either one of them.
Most people get a standard repayment mortgage, in which you borrow a certain amount from a lender to buy a house and then pay the lender back chunks of the loan plus interest each month. Interest-only mortgages were once far more prevalent than now, but since the 2008 financial crisis, banks and mortgage lenders have been more cautious and restrained in lending and now perform stringent checks to ensure you can pay them back.
However, you can still get interest-only mortgages and they are particularly favoured by landlords purchasing a buy-to-let property, though anyone can apply for one. But would it be right for you?
We are going to help you find out as we explore interest-only mortgages, find out what they are, how they work, and whether you should get one or not.
What are interest-only mortgages?
An interest-only mortgage is a mortgage scheme whereby you only pay the interest charged each month until the mortgage period is over. Once the mortgage period comes to an end, you repay the full value of the mortgage in one payment.
Interest-only mortgages are good for some borrowers as they mean you pay much less every month. However, they also demand a huge payment at the end of the mortgage period, which you must prove you can pay back before a lender will offer you a mortgage.
So let’s jump in and look at the details of how interest-only mortgages differ from standard repayment mortgages.
How are interest-only mortgages different from other mortgages?
Regular mortgages are often known as “repayment mortgages.” Although there are different types of repayment mortgages, they all involve the borrower paying back a small part of the loan each month, plus interest.
With an interest-only mortgage, the borrower only pays back the interest every month and then pays the total loan back at the end of the mortgage period. This means that your monthly repayments are small in comparison to a repayment mortgage, but you have to have the money available to pay off the rest of the loan at the end of the mortgage period.
Let’s compare the two types of mortgages with an example. Let’s say you borrow £200,000 and have a mortgage that runs for 25 years with a fixed interest rate of 3%.
- If you opt to get an interest-only mortgage, you’d pay £500 a month. £500 per month totals £6,000 per year, and £6,000 is 3% of £200,000. Over the course of 25 years, you would end up paying £150,000 interest and then still have to pay the lender £200,000 at the end of the mortgage period. So your total expenditure would be £350,000
- If you opt for a repayment mortgage under the same terms, you would pay back £948.42 per month. So, over the same 25-year period, your total expenditure would be £284,526.79.
As we can see, a repayment mortgage often works out as substantially cheaper than an interest-only mortgage. So why would someone choose to get an interest-only mortgage?
What are the advantages of an interest-only mortgage?
Interest-only mortgages can be a good option if you have a solid plan on how to save enough money for the final repayment at the end of the mortgage period.
The lower initial payments offer greater flexibility and mean that an interest-only mortgage is a good idea if you are expecting a windfall payment or for your income to rise over time.
Interest-only mortgages are particularly favoured by landlords who buy-to-let. Interest-only mortgages keep the overheads low and mean that the rental income generated from the property is higher than the outgoings. The loan can then be paid off by selling the property at the end of the mortgage period, and the rental income can be saved as profit.
What are the disadvantages of an interest-only mortgage?
The main disadvantage of an interest-only mortgage is the fact that at the end of the mortgage period, you will have to pay a huge lump sum. This doesn’t have to be a problem if you are secure in the knowledge of how you will have access to that money. However, if you rely on other investments coming through to pay off the loan at the end and those investments don’t come to fruition, you could be in trouble.
As we have already seen, an interest-only mortgage often works out as being more expensive overall than a standard repayment mortgage. While this isn’t always the case, it usually is.
Should you get an interest-only mortgage?
Interest-only mortgages are only suitable for people who have a good amount of equity and a solid repayment plan to pay the loan back.
Mortgage lenders have stricter rules surrounding residential properties paid for with interest-only mortgages. You will normally only be allowed to borrow up to a certain amount of the property value (often around 50%), you will need a large deposit to make up the rest.
Some lenders also only offer interest-only mortgages to individuals with high-income salaries, as they want to see that the saving plan is realistic.
The rules surrounding buy-to-let interest-only mortgages are more relaxed. Interest-only mortgages are the standard for these purchases, and the landlord can use the rental profits as part of the savings plan.
What is a repayment plan?
Before a mortgage lender offers an interest-only mortgage, they will ask to see and approve a repayment plan. A repayment plan can include money garnered from renting the property, ISAs, investments in stocks and shares, or savings from your income.
Your lender will then make checks throughout the mortgage period to ensure you are on track to have enough money to pay the lump sum at the end.
Interest-only mortgages and the financial crisis
Before the 2008 financial crisis, interest-only mortgages were very popular, especially in the US. Borrowers could find interest-only deals without showing the lenders how the loan would be repaid at the end of the mortgage term. Many people could then not pay off the debt at the end of the term, which became known as the subprime mortgage crisis.
The subprime mortgage crisis was one of many reasons the global banking system collapsed in 2008. It also meant that many banks and building societies were much less likely to offer interest-only mortgage deals to people other than buy-to-let landlords.
What are retirement interest-only mortgages?
A retirement interest-only mortgage (sometimes known as an “RIO mortgage”) is specifically for people either in or approaching retirement.
Most RIO mortgages stipulate that you only pay monthly interest and repay the loan when you sell the property, move into residential care, or die. However, some RIO mortgages still set a mortgage period like regular interest-only mortgages.
With an RIO mortgage, you don’t have to prove your income and savings plan, you only have to show that you can afford the interest payments.
You can also find RIO mortgages that allow you to repay some of the loan as well as the interest, which means that more of the money from the property sale can be passed on to family and loved ones.
What happens if you can’t repay an interest-only mortgage?
If your loan has not been repaid in full by the end of the mortgage period, the lenders have the legal right to repossess your home.
This can happen in cases where people planned to pay off the loan by selling the house, but the house has fallen in value. This is known as being in “negative equity.”
If you are nearing the end of your mortgage period and are worried about being unable to pay it off, options are available. Some lenders will offer you some of these options in each instance, while others won’t.
So, if you can’t repay your interest-only mortgage, you can:
- Change to a repayment mortgage. Switching to a repayment mortgage also means that your monthly payments would rise significantly in the short term, though you may also be able to lengthen the mortgage period and thereby reduce the monthly payments.
- Extend your mortgage period. You may be able to extend the time frame of your interest-only mortgage repayments, which would allow you more time to save, invest, or for the property to accrue value. This also means that you will pay more interest on the mortgage, but that may be worth it in the long run.
- Remortgage the property. You could look into remortgaging the property under a more competitive deal, but this is not a secure option, especially if you are in negative equity.
- Withdraw your pension. You can withdraw up to 25% of your pension tax-free. This can be a sizeable sum, especially for those nearing retirement age. However, it does mean your retirement plans will also be impacted.
- Sell the property. If your property has risen in value or stayed the same since you bought it, you have the option of paying back the loan by selling your property. Although people often don’t want to leave the home they’ve lived in for many years, sometimes there are few other options.
Interest-only mortgages work similarly to standard repayment mortgages, but your monthly mortgage payments cover just the interest on the mortgage and not the loan itself, which is paid in a lump sum at the end of the mortgage term. The main advantage of an interest-only mortgage is that the monthly payments are much smaller than a regular mortgage. However, you have to prove that you will be able to pay the hefty sum at the end of the period, and you will usually end up paying back more than a regular mortgage on the same property.
But if you are a landlord looking for new property investment, a retiree, or expecting a windfall in the coming years, an interest-only mortgage could be perfect for keeping your costs down in the short-term and making a long-term investment in your future.