Interest Only Mortgage: How Does It Work?

An interest only mortgage is a loan where the borrower only pays the interest each month without reducing the actual loan amount, also known as the capital. This structure results in lower monthly payments during the mortgage term, but the full loan amount must be repaid at the end of the term. Let’s dive into how interest only mortgages operate, how repayments work, and whether they might suit your financial situation.

What Is an Interest Only Mortgage?

In an interest only mortgage, the borrower is required to pay the interest on the loan, leaving the capital untouched. This means that throughout the term, whether it’s 10, 20, or 25 years, the size of the loan remains the same.

For example, if you borrowed £150,000 for 20 years on an interest only basis, you’d still owe £150,000 at the end of the mortgage term, regardless of how much interest you’ve paid over the years.

How Do Monthly Payments Work?

The monthly payments in an interest only mortgage are relatively simple to calculate. Since you’re only paying the interest, the payment amount will depend on your loan size and the interest rate.

Example:

If you have a £100,000 loan at an interest rate of 4%, your annual interest would be £4,000. Dividing that by 12 gives a monthly payment of around £333. However, this does not reduce the original loan, meaning at the end of the term, the £100,000 remains outstanding.

On the other hand, with a traditional repayment mortgage, your monthly payment would include both interest and a portion of the capital. This would lead to a higher monthly payment but reduce the loan balance over time.

What Happens When the Mortgage Term Ends?

At the end of the interest only mortgage term, you must repay the entire loan. How you do this is something you need to plan from the start. Without a repayment strategy, you may find yourself in financial difficulty.

Ways to Repay an Interest Only Mortgage

There are a few options to consider when it comes to repaying your loan at the end of the mortgage term. Let’s explore some common strategies:

1. Remortgaging

When your interest only mortgage term ends, you could look to remortgage the property. This involves taking out a new mortgage to pay off the original loan. However, keep in mind that eligibility criteria might become more difficult as you get older, and your financial circumstances may change over time.

2. Selling the Property

A popular option, especially among buy-to-let investors, is to sell the property and use the proceeds to pay off the mortgage. If property values have risen during the mortgage term, you may even make a profit. But be aware of the risks of negative equity, where the sale price may not cover the full loan.

3. Using Savings or Investments

Some borrowers rely on savings or investments to clear their mortgage at the end of the term. While this can work well if your investments perform as expected, there’s always a risk that your savings won’t grow enough to cover the debt.

Key Considerations Before Taking Out an Interest Only Mortgage

Before you decide if an interest only mortgage is right for you, there are several key factors to consider:

1. Evaluate Your Options

Interest only mortgages may not be suitable for everyone. Compare this type of mortgage with traditional repayment mortgages and other alternatives. Speaking with a mortgage broker can help you explore which option best fits your situation.

2. Plan Your Repayment Strategy

It’s crucial to have a plan in place for how you’ll repay the loan when the term ends. Lenders will often require proof of this repayment plan before they approve your mortgage.

3. Check Your Credit Score

Your credit score will play a major role in your ability to secure a mortgage. Make sure your score is as strong as possible before applying.

4. Can You Afford It?

While the monthly payments may be lower, don’t forget that you’ll still need to repay the full loan at the end of the term. Use a mortgage calculator to assess your affordability before making any commitments.

What Happens If You Can’t Repay the Loan?

If you’re unable to repay the capital at the end of the mortgage term, your lender may require you to sell the property. Should the sale not cover the full loan, you may face further financial difficulties, potentially putting other assets at risk.

Pros and Cons of Interest Only Mortgages

Advantages:

• Lower Monthly Payments: One of the biggest benefits is the lower monthly cost compared to a repayment mortgage. This allows more financial flexibility in the short term.
• Potential to Borrow More: Because monthly payments are smaller, you might be able to borrow a larger sum than with a repayment mortgage.
• Good for Buy-to-Let Investors: Many landlords favour interest only mortgages as they can sell the property to cover the loan later.

Disadvantages:

• Loan Remains Unpaid: While monthly payments are lower, the loan amount stays the same throughout the term. You’ll still need to find a way to pay it off.
• Higher Overall Cost: Over time, an interest only mortgage can be more expensive, as you’re paying interest without reducing the loan.
• Stricter Lending Criteria: It’s harder to find lenders offering interest only deals, particularly for first-time buyers. You may need a larger deposit and a higher income to qualify.

Common Questions About Interest Only Mortgages

Can I Switch to a Repayment Mortgage?

Yes, you can switch from an interest only mortgage to a repayment one at any time, either through remortgaging or transferring your mortgage product. This can help you reduce the loan amount over time.

Can I Extend My Mortgage Term?

If you’re struggling to repay the capital, extending your mortgage term may be an option. However, speak to your lender as soon as possible to discuss this.

What About a Part Interest Only, Part Repayment Mortgage?

You might also consider a hybrid mortgage where part of the loan is interest only, and part is repayment. This can help ease the transition while gradually reducing your loan balance.

Is an Interest Only Mortgage Right for You?

Whether an interest only mortgage suits you depends on your financial circumstances, future plans, and confidence in being able to repay the loan. Those with a solid repayment strategy or who plan to sell a buy-to-let property may find it appealing, but it’s less suitable for first-time buyers or those without a clear financial plan.

It’s always wise to consult a mortgage broker or financial adviser before making your final decision.