While most mortgage deals are repayment mortgages – where you pay off a chunk of what you borrowed in addition to interest – it’s also possible to get interest-only loans.

These deals mean lower repayment costs, but when the term is up you’ll usually need to have a plan of how to repay the lump sum that’s still owing.

Here, Telegraph Money explains how interest-only mortgages work, and what advantages and disadvantages you should be aware of.

• What is an interest-only mortgage?

• Interest-only mortgage vs repayment mortgage

• How to get an interest-only mortgage

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

• Interest-only mortgage FAQs

What is an interest-only mortgage?

An interest-only mortgage is when you opt to pay just the interest on your borrowing each month, rather than a combination of interest and the capital you borrowed.

While repayment mortgages are geared up so that you have paid back the full loan amount by the time the mortgage term ends, with an interest-only mortgage the remaining capital will still be owing. You’ll have to agree to repay this amount when the time comes, and prove you have a plan for how to do this.

The most recent data shows that at the end of 2022 there were just under 1 million interest only mortgages running, with the peak time for maturity in 2031 (92,000) and 2032 (95,000).

How does it work?

The repayments are set up on a direct debit, just as with a repayment mortgage, albeit with much smaller amounts. This makes it a tempting option for those who are struggling to afford their full mortgage repayments.

Borrowers are expected to make sure they have a plan in place to pay off the debt at the end of the term. They will either use savings, investments, pensions, sale of property or change to a different type of mortgage.

Previous research from the City watchdog – the Financial Conduct Authority (FCA) showed that some interest-only borrowers may have overestimated their ability to repay their loan. The research found 82pc were confident about repaying, yet 36pc expected to have a shortfall.

Mark Harris, chief executive of mortgage broker SPF Private Clients, says: “For the right borrower in the right circumstances, and for the right reasons, interest-only can be a great way to manage your mortgage repayments.

“The availability and breadth of interest-only products is better than it has been for a long time. Lenders are returning to the market offering higher loan-to-values (LTVs), allowing multiple strategies for repayment of the loan and a combination of repayment and interest-only options.”

 

There is another iteration of the interest-only mortgage that is worth noting which offers a shorter-term solution for those who need some temporary financial breathing space. Available for up to six months, mortgage holders can switch their repayments to interest-only under the Mortgage Charter, which was introduced in 2023. This agreement, signed up to by most major lenders, enables them to offer flexible support to those who are struggling with repayments.

When it comes to interest-only switches, your mortgage will revert back to its usual repayment structure after the pre-agreed time period. Note that it will likely be more expensive, due adding the money you didn’t pay during the “break”. There are no affordability checks during the application or reversion, and it shouldn’t impact your credit score.

Interest-only mortgage vs repayment mortgage

• Interest-only payments just cover the interest, while repayment mortgages cover both the interest and the capital on the loan.

• Repayment mortgages gradually reduce the size of the capital you owe, meaning interest payments gradually reduce too. With interest-only, you’ll pay interest on the full loan amount for the entire term.

• With a repayment mortgage you pay off the loan in full by the end of the term. With interest-only, at the end of the mortgage term you will still owe the original sum borrowed – payable in a lump sum.

How to get an interest-only mortgage

Getting an interest-only mortgage is similar to a repayment mortgage.

1. Find a competitive mortgage by using a comparison service or a mortgage broker.

2. Make your application, providing details of income and outgoings as well as any debt and large financial commitments such as school fees or child maintenance.

3. You will need to pass affordability tests which comprise looking at your income and outgoings, and the lender will perform a credit check.

4. To be eligible for interest-only, you will need to demonstrate that you have a repayment vehicle in place. Mark Harris added: “Lenders insist borrowers hit certain income levels, cap LTVs or terms, require proof of any repayment vehicle(s) and have minimum equity collars to qualify. Most lenders will also stress test the borrowing on a repayment basis.”

5. As long as you are accepted, a formal mortgage offer will be made and the money will be made available for completion day on a new home or on the day you want to remortgage.

Advantages

• Your monthly payments will be much lower than with a repayment mortgage.

• Interest-only mortgages are flexible, with most lenders enabling borrowers to make overpayments if they can afford to.

• They work well longer term; when house prices are soaring as you can pay off the loan and make a healthy profit.

Disadvantages

• Your monthly repayments do not go towards paying off any of the mortgage balance, so the amount you owe at the beginning of the term will be the same at the end.

• If house prices fall you might be left with less than you borrowed.

• If you cannot pay the capital off when the mortgage comes to an end you are at risk of losing your home.

• Interest-only loans tend to cost more overall as you’ll pay interest on the full loan amount for the entire term, and then have to pay off the loan in full at the end.

• Some lenders charge a premium for interest-only compared with repayment mortgages. Others may only let you borrow up to 50pc of the equity.

Can you pay off an interest-only mortgage early?

Should you wish to pay off your mortgage – perhaps because you’ve received a windfall, for example – you can do so, but there may be some fees to pay.

If your existing loan is still within the fixed period you will likely pay an exit penalty known as an early redemption charge (ERC). This is usually tiered, so the charge reduces as time goes on. There might also be a one-off redemption fee added for a few hundred pounds to cover admin costs.

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

When your interest-only mortgage expires, you will need to clear the loan – which will likely be the original amount you borrowed to purchase your home, unless you’ve made overpayments.

If you’re unable to pay off the loan, and don’t want to sell the property, you might need to take out a fresh repayment mortgage for this. This is more straightforward now that most lenders will offer mortgages until 75 or even older.

Other options for when the loan ends can include retirement interest-only mortgages. This is designed for older people who need to continue borrowing into later life. As long as you can afford the repayments you do not need to worry about clearing the capital balance until the property is sold.

Interest-only mortgage FAQs

Can I change my interest-only mortgage to a repayment mortgage?

This should be possible, as long as you pass the affordability tests after assessing your income, expenses, and overall debt levels, then your mortgage lender should approve your application to switch to repayment. Some lenders may have specific criteria or fees that must be met before they will allow you to change.

If your current lender won’t assist with a switch, you could consider remortgaging to another lender.

If you’re unable to switch your entire loan to a repayment mortgage, you can explore switching part of it, again either with your current lender or a new one.

Can I sell my house if I have an interest-only mortgage?

Yes, you can – the ownership status of a home is no different whether you have opted for an interest-only or repayment mortgage. You can sell your home whenever you wish – as long as you can find a buyer.

If your mortgage is still within a fixed period you will either need to port it (if allowed) or redeem it. If you redeem it – that is, pay it off – there may be an early repayment charge. These charges are tiered, reducing as time goes on, but check for the exact fees with your lender. They will be detailed in your original mortgage offer documents.

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

There are several options to borrowers who do not have the means to repay the capital part of an interest-only mortgage when it comes to an end.

Firstly, it may be possible to extend an interest-only loan – but not always. It’s typically assessed on a case-by-case basis.

You also have the option to take out a new repayment mortgage, as long as you meet the affordability requirements. You might also consider equity release.

It’s important to speak to your lender or mortgage adviser as soon as you know you have a shortfall. The more time you have to sort an alternative the better. Leaving it until the last minute won’t help matters.

It can ease the pressure to make overpayments along the way – within the rules that means you don’t trigger any early repayment charges.

 

Source: yahoo.com

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