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What is an interest-only mortgage?
An interest-only mortgage is a type of home loan that allows borrowers to make monthly payments only toward the interest owed on the loan, for a specific period of time. In comparison to a repayment mortgage, where monthly payments are applied to both the outstanding principal balance and the interest owed on the loan, an interest-only mortgage requires borrowers to make significantly lower monthly payments during the initial stages of homeownership.
Interest-only mortgages were popular before the financial crisis of 2008, but they have since become much less common.
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What about repayment mortgages?
A repayment mortgage is the most common type of home loan. With a repayment mortgage, your monthly payments are applied to both the interest owed on the loan and the loan principal.
With a capital repayment mortgage, the monthly payments are split so that a proportion goes towards interest, and a proportion goes towards repaying the amount borrowed. The borrower therefore gradually reduces the amount of money they owe the lender, as well as the total amount of interest payable over the life of the mortgage.
The advantage of a repayment mortgage is that it allows you to pay off your loan faster than an interest-only mortgage. The disadvantage of repayment mortgages is that your monthly repayments will be higher, as you are paying off the interest and the loan principal each month.
Repayment mortgage vs interest-only mortgage
In contrast to a repayment mortgage, where the monthly payments cover both interest and some of the loan amount (the principal), an interest-only mortgage leaves the full loan amount outstanding throughout the term.
You'll need repayment plan in place for an interest-only mortgage.
If you have an interest-only mortgage, it's important to remember that you'll still need to repay the full loan amount at the end of the mortgage term. This means having a repayment plan in place for when the interest only term ends.
Who can get an interest-only mortgage?
Interest-only mortgages are typically reserved for borrowers with strong credit and healthy incomes who are confident they will be able to afford to maintain a solid repayment plan.
Mortgage lenders require you to have a repayment strategy, which could be in the form of investments, savings or other assets, in order to qualify for an interest-only mortgage.
Interest-only mortgages can be a good option for borrowers who are looking to keep their monthly repayments low, at least initially. But because these loans require borrowers to eventually pay back the principal as well as the interest, they can end up being more expensive in the long run.
Be sure to talk to an experienced mortgage broker (like our team at Teito!) to see if you're a good candidate for this type of mortgage.
What are the benefits of an interest-only mortgage?
Lower monthly repayments - For borrowers who are confident they will be able to afford the higher payments that will be required down the road, these types of loans can be a good option.
Flexibility - Compared to a repayment mortgage, where monthly repayments go toward both the interest and the principal, an interest-only mortgage allows borrowers to put more of their money toward other financial goals. For example, with an interest-only mortgage, you may have more money available each month to save for a deposit on another property or invest in a rental property.
What are the downsides of an interest-only mortgage?
Of course, there are also some potential drawbacks to taking out an interest-only mortgage.
They can be more expensive: Because borrowers are not paying down any of the loan’s principal balance during the interest-only period, they may end up owing more money than they would with a traditional mortgage.
You’ll build equity more slowly: Since you're not paying down any of the loan's principal balance during the interest-only period, you won't be building equity in your home as quickly.
You'll need to maintain your repayment vehicle: At the end of the mortgage term, you'll need to implement your repayment plan to pay off the entire loan amount.
It’s important to speak with a financial advisor or mortgage professional before deciding whether an interest-only mortgage is right for you.
They can help you evaluate your unique circumstances and make sure you are taking on a manageable level of risk. Remember, as with any loan secured against your home, there is always the risk that your home may be repossessed if you can't make your payments.
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What are the risks of an interest-only mortgage?
The main risk with a interest only mortgages is that you are liable to pay off the entire principle loan amount at the end of the mortgage term. This can put a great deal of pressure on your finances, which is why these types of mortgages are only suited to those with a solid repayment plan in place.
Another thing to keep in mind is that, because you're not building equity in your home as quickly with an interest-only mortgage, you may have less home equity to borrow against if you need to take out a home equity loan or line of credit down the road.
What happens at the end of an interest-only mortgage?
At the end of the interest-only term, you will still owe the full loan amount. This means that borrowers will need to pay off the loan in full, or remortgage to a new mortgage deal.
Examples of Repayment Plans for Interest-Only Mortgages
At the end of the mortgage term, your mortgage lender will expect the full loan amount to be repaid. This means implementing your repayment plan to pay off the entire loan amount.
Examples of a mortgage repayment plan for an interest-only mortgage:
Investments: If you have investments, such as stocks, bonds or a mutual fund, you can use these as a repayment vehicle for your interest-only mortgage. When it comes time to repay the loan, you can sell the investments and use the proceeds to pay off the mortgage.
Savings: You can set up a savings plan specifically for the purpose of repaying your mortgage. For example, you could set up a monthly automatic transfer to a savings account to put money aside for when the mortgage term ends.
Buy to Let Property: Another option is to purchase a buy-to-let property and use the rental income to repay the mortgage. This option can be a good way to build equity in another property while also repaying your interest-only mortgage.
What if I can't repay the capital at the end of the term?
If you can't repay the loan in full at the end of the term, there are options available to you.
Extend the term: You may be able to extend the term of your mortgage, which will give you more time to repay the loan. This option will likely come with an increase in interest payments, as well.
Refinance: You could also refinance to a new mortgage loan with different terms.
Sell the property: You could sell the property and use the proceeds to repay the mortgage.
Interest-only mortgages can be a good option for some borrowers, but they're not right for everyone. Be sure to speak with a financial advisor or mortgage professional to see if an interest-only mortgage is right for you.
What is the longest term for an interest-only mortgage?
Generally, an interest-only mortgage term tends to vary between 5 and 25 years. The terms offered will depend on the lender, so it's important to shop around to find one that meets your needs
How much deposit do I need for an interest-only mortgage?
As interest only mortgages are seen as higher risk, mortgage lenders will want to you to have a lower LTV than for a repayment mortgage. This means that you'll need to have a larger deposit saved up in order to qualify.
Generally, you'll need a deposit of at least 15% for an interest-only mortgage. However, some lenders may require a 20% or even 25% deposit. In contrast, you could find a repayment mortgage with a much lower deposit, such as 5%.
The amount of deposit you'll need for an interest-only mortgage will depend on the lender you choose and the type of mortgage you're applying for.
Can I get an interest-only mortgage with a bad credit score?
If you're struggling with bad credit, you may still be able to qualify for an interest-only mortgage.
However, your options will likely be limited and you may have to pay a higher interest rate. Talk to an experienced mortgage broker to learn more about your options.
Compare interest-only mortgages
At Teito, we're a whole of market mortgage broker, which means we can compare interest-only mortgages from a range of lenders to find the one that's right for you.
Our mortgage advisors are on hand to answer any questions you have about interest-only mortgages and help you find the best deal for your needs.
To compare interest-only mortgage deals, get started today and we promise to make the process as straightforward and stress-free as possible!
Choosing an Adviser
Selecting a qualified and experienced mortgage adviser is of great importance. To choose a suitable adviser, evaluate their qualifications, experience, and reputation, and ensure they are regulated by the Financial Conduct Authority (FCA).
Read reviews from previous clients and make sure they provide a clear explanation of the products and services they offer, as well as the fees and charges associated with them.
Last updated 21 February 2024