Everything you’ve ever wanted to know about interest only mortgages
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If you’re looking to buy a property, you may have considered the possibility of interest only mortgages. We are approached all the time about interest only loans from UK borrowers as they have additional criteria and factors to consider, and can be harder / more complex to arrange than a traditional repayment mortgage.
The following topics are covered below...
So what are interest only mortgages, and how do they work? By definition, it’s pretty much what it says on the tin. If you take out an interest only mortgage, you borrow money for a for a property but only repay the interest owed to your lender each month.
You do not pay off any of the capital that you owe until the end of the mortgage term. Paying back interest only on a mortgage can be a tempting prospect as the monthly payments are considerably lower than the “usual” repayment mortgages, which can make them appear more affordable for buyers.
But this can be deceptive; as you’re not paying back anything you borrow, you are then required to repay the total capital owed at the end of the mortgage term.
What’s more, you must also provide your lender with substantial proof that you are able to afford these repayments at the end of the period. We’ll discuss this in more detail later on.
Interest only mortgages differ from repayment mortgages in the sense that, with repayment mortgages you gradually repay the money you’ve borrowed on the full mortgage amount throughout the agreed term. With repayment mortgages you make one payment a month to your lender, part of which goes towards repayment of the actual loan, and the rest covers the interest. This means your monthly payments are higher than that of an interest-only. For in-depth information about how interest-only mortgages compare to repayment mortgages, check out our dedicated article on the topic.
When it comes to interest only mortgages, you’re only paying the mortgage interest to your lender, so your monthly payments can be far lower than a repayment mortgage. However, this means you will need to make other arrangements for paying back the full capital. This is referred to as setting up a “repayment vehicle”, which can either mean paying a separate monthly sum into another investment, or using another asset / investment that already has a value that would cover the loan. You will also need solid proof of a legitimate repayment vehicle in place to pay off the capital of your mortgage later on. Acceptable repayment plans vary by lender, and may include (but not limited to)…
Your lender is also likely to make required checks that your chosen repayment plan is on track to pay the required amount. Interest only lending was very popular a decade or so ago, when many buyers were able to borrow on an interest-only basis without showing lenders proof of how their debts would be repaid. However, it later emerged that a huge number of interest-only customers were struggling to pay off their loan at the end of their term, a massive problem which has lead to tighter regulation and requirements.
Nowadays it is a lot more challenging to borrow on an interest-only basis; far fewer lenders are willing to offer this type of loan (therefore limiting your choice and access to the most competitive rates), and those that do will have strict criteria, typically in the form of a high deposit. Most lenders require at least 25% deposit, max lending to 75% loan to value (LTV). Some can consider up to 80% LTV, and a handful 85%
As we’ve established, taking out an interest-only mortgage can be risky unless you can be certain that your chosen repayment vehicle will be able to fund paying off your mortgage at the end of the term. If your investment doesn’t prove fruitful, you will face a shortfall later down the line. This is especially significant if you’re considering taking out an interest only mortgage for your main place of residence.
Provided you have a sound repayment plan in place however, there are pros to the scheme which include:
As you are only paying back the interest on your loan your monthly payments will be far lower than with a repayment mortgage. For example, if you borrow £200,000 interest-only over 25 years at an interest rate of 3%, you’d pay £500 a month. If you were to repay the mortgage on an repayment basis you’d be set back £948 a month. But bear in mind that, while this approach makes a mortgage more affordable in the short term, in this scenario it would mean that after the 25 years were up you’d still owe the lender £200,000.
You have the ability to decide how you repay the capital of your mortgage after the period is up. For example, you could put the money you save into home improvements (thus increasing the value of the property), alongside setting some away into a savings plan each month.
If you invest in a sound repayment vehicle, you may be left with a lump sum that not only covers your mortgage repayments, but gives you some extra cash to play with. This could be used towards increasing your mortgage payments (therefore allowing you to pay off the capital and gain more equity in the property faster), or put towards home improvements or other means as you see fit.
There are also considerable cons to consider, regardless of whether or not you have a stable repayment vehicle in place:
With interest-only schemes you can end up paying more interest in the long run, as you are charged interest on the full sum borrowed for the duration of the term.
Payment must be made after the interest-only term ends. Even though you’ll benefit from the perks of smaller monthly payments initially, you need to have a good plan in place as to how you’re going to repay the capital, otherwise you risk losing your home.
Interest only mortgage rates don’t tend to be drastically different to typical repayment mortgage rates – provided there is strong evidence that you are able to repay the capital, and of course taking individual circumstances into account. It’s also useful to note that, due to the associated risk with this type of mortgage there are fewer lenders offering to lend, especially at higher Loan to value (LTV), therefore you may be more limited in your options and less likely to be offered the most competitive rates on the market. But that doesn’t mean finding a deal with favourable rates is impossible. If you’ve decided this product might be for you, get in touch and the advisors we work with will help you find the lender offering the best deals for somebody in your circumstances.
If you’re concerned that you aren’t going to be able to pay off the capital owed at the end of the period, you should take action as soon as possible – even if you’re years away from the end date. There are several options available to you, including:
Find out more on this here.
While interest only mortgages are not generally recommended for first time buyers, they are usually the go-to option for buy to let landlords. Most lenders are happy to accept BTLs on an interest-only basis (other factors taken into consideration). This is because it is assumed that the property will be sold to repay the mortgage at the end of the term – although this of course relies on the housing market being resilient so the house is worth the same or more than what it was at the time of purchase.
Another way an interest-only mortgage can be beneficial is if you already own your home outright, or own a considerable amount of equity in the property. For individuals over the age of 55, you may be eligible to take out an interest only lifetime mortgage. This is a cost-effective form of equity release which is essentially a long-term loan secured on a property that you either fully or partially own. This scheme allows you to withdraw a lump sum of cash from the equity you own, which you can spend on whatever you please. Interest is charged on the amount you’ve borrowed, which can be paid off, or more commonly, added onto the total loan amount. For more information about interest-only lifetime mortgages, consult our dedicated page on the topic.
Something else to consider is the location in which you’re planning to buy. For example, interest only mortgages in London and certain parts of Scotland, including Edinburgh, are more common than in other cities due to the price of properties in the area. Lenders may be more understanding considering that expensive repayment mortgages may be the only option for many buyers, and therefore you may have access to a greater number of lenders as the scheme is more common. On the other hand, other areas of the UK are far cheaper to buy in such as Belfast, Northern Ireland, and less densely populated of Wales, meaning that interest-only mortgages may be less common. Regardless of the location however, you will still have to have proof of a sound investment vehicle in place in order to be approved.
As ever, there are a number of other factors that can impact your eligibility for a mortgage application.
Having certain types of credit issues can limit the number of providers willing to lend to you, so as a result the rates available can be higher. That’s said, approval mainly depends on the type of issue, and when it was registered, and it’s possible to get approved on interest only mortgages with late payments, defaults, CCJs, Mortgage arrears, Debt Management Plans, IVAs, Repossessions and Bankruptcy.Thankfully there are specialist lenders out there who cater for borrowers with credit issues, and the advisors we work with work with them on a daily basis, so make an enquiry and they will help you find the most favourable deals. For detailed information about interest only mortgage eligibility, head over to our dedicated page for this subject.
If you’d like more advice on interest only UK mortgage loans, call Online Mortgage Advisor on 0808 189 2301 or make an enquiry here. Then sit back and let us do all the hard work in finding the broker with the right expertise for your circumstances. We don’t charge a fee, and there’s no obligation or marks on your credit rating.
A mortgage payment holiday is an agreement you can make with your lender which allows you to temporarily stop or reduce your monthly repayments. When your payment holiday ends you have to start repaying again. After which time the payments usually increase to make up for the missed months’ and extra interest owed. Not every lender offers this, so check the T&Cs of your terms.
Previously, Buy to Let investors would only have to pay income tax on their net rental income, having deducted any interest and allowable expenses throughout the year. From April 2020 this will no longer be possible.
Lenders are very unlikely to accept cash for any type of deposit unless there is proof that it comes from a legitimate source and can in no way be associated with money laundering. Neither is cash acceptable as a legitimate repayment vehicle in which to pay off the capital at the end of an interest only mortgage term.
Yes, of course. As long as you meet the lender’s eligibility and affordability requirements, you should be able to refinance onto another interest-only product. You can read more on this in our guide to interest-only remortgages.
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*Based on our research, the content contained in this article is accurate as of the most recent time of writing. Lender criteria and policies change regularly so speak to one of the advisors we work with to confirm the most accurate up to date information. The information on the site is not tailored advice to each individual reader, and as such does not constitute financial advice. All advisors working with us are fully qualified to provide mortgage advice and work only for firms who are authorised and regulated by the Financial Conduct Authority. They will offer any advice specific to you and your needs.
Some types of buy to let mortgages are not regulated by the FCA. Think carefully before securing other debts against your home. As a mortgage is secured against your home, it may be repossessed if you do not keep up with repayments on your mortgage. Equity released from your home will also be secured against it.
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