While they used to be very popular before the credit crunch, interest only mortgages are a much rarer sight today. Still, as a means of securing a home with more affordable payments in the short term, they are a viable option to consider. But what exactly is an interest only mortgage, and how does it work?
What is an interest only mortgage?
An interest only mortgage is where you only make monthly repayments on the agreed interest you owe. For example, if the agreed annual interest rate on your £200,000 mortgage is 3%, you would only repay that 3% over the course of the year, split into 12 monthly repayments of £500 each.
However, this means that at the end of the agreed mortgage term (usually this is about 20-25 years), you will still owe the full £200,000 you originally borrowed. You will only be paying off the interest each month, without reducing the capital sum at all.
Interest only mortgages are an alternative to a ‘repayment mortgage’. This is where you slowly pay off the balance of your mortgage each month, along with the interest.
Is an interest only mortgage better than repayment mortgages?
An interest only mortgage is not better or worse than a repayment mortgage, they are just different financing options. If you want a mortgage with the smallest possible monthly payments, then an interest only mortgage may be preferable. If you want to work off the debt over time, then you will need to secure a repayment mortgage.
Why would you get an interest only mortgage?
You might want to get an interest only mortgage if you don’t want to rent property but can’t afford higher monthly payments. Given that interest only payments are lower, you might also be able to borrow more, securing you a more expensive property.
Interest only mortgages can also be useful if you are looking at a buy-to-let setup. By keeping your monthly payments low, you can make more profit from the rent initially. Then you can sell the property later on to pay off the mortgage loan.
How easy is it to get an interest only mortgage today?
Interest only mortgages are much difficult to secure now than they were before the financial crisis of 2007. Mortgage lenders always need to know that you have a viable plan for repaying your loan.
This means that buyers – especially first-time buyers – looking for an interest only mortgage are seen as a higher risk. As such, you may be asked to provide a higher deposit on the property than with a repayment mortgage.
What happens at the end of an interest only mortgage?
At the end of your agreed interest only mortgage term you will have to repay the full capital sum. So, if you borrowed £200,000 originally, you will need to repay the whole £200,000.
However, you may also have the option to extend your mortgage term. You will have to consult with your lender, preferably one or several years before the original term is up. If you leave it too late, they may be concerned that you won’t be able to repay, and they may not agree to extend the term.
How long can you have an interest only mortgage?
Technically, you can have an interest only mortgage for an indefinite amount of time. As long as your mortgage provider is willing to keep extending the term, you can carry on with just the monthly interest payments.
Some interest only mortgage agreements have a clause in them where the capital sum will be repaid from the sale of the property when the owner dies. Retirement mortgages are becoming a big hit with older borrowers.
Can I make overpayments on an interest only mortgage?
Yes, you can make overpayments on an interest only mortgage. This is one way to reduce the capital sum and the monthly interest payments. You simply overpay what you can afford, when you can afford it.
Can I change to an interest only mortgage?
If you are on a repayment mortgage, you can switch to an interest only mortgage. You can also switch from interest only to repayment.
You will need to talk to your mortgage provider about the products they are willing to offer you. Alternatively, you can consult a mortgage broker to find another set of options with different lenders.
Is an interest only mortgage a bad idea?
An interest only mortgage is not a bad idea, if you are confident that you can repay the capital sum. It is a useful financing option for securing a mortgage with minimal monthly payments. It’s also a good option for landlords looking to generate short-term rental profits while their property appreciates in value.
However, anyone looking to secure an interest only mortgage should be aware of the downside. The total amount you repay will be higher than with a repayment mortgage. Also, finding the full capital sum all at once at the end of the mortgage term might prove financially challenging.
If you need more advice on mortgage options, we have a guide specifically covering bad credit mortgages, as well as a first-time buyer’s guide to getting a mortgage.
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