Interest-only mortgages offer cheaper monthly repayments but what’s the catch?
There are two ways of paying your mortgage each month; repayment or interest-only. An interest-only mortgage means only paying the interest on the balance of your mortgage each month, and not paying back any of the money borrowed.
Interest-only mortgages are the cheaper option for monthly payments, but are riskier and can end up being more expensive in the long term.
Whilst this makes your monthly repayments smaller than a full-repayment mortgage you do not pay back your mortgage and you will never shrink your debt.
How do interest-only mortgages work?
As you do not pay back your mortgage debt you are, in effect, renting your home from your lender. Once the term of your mortgage finishes you will be expected to repay the balance of money owed.
Generally this would be done by selling your home and using the proceeds of the sale to repay the debt. This can also done with a ‘repayment vehicle’ – an investment or saving that matures alongside the mortgage to reach the level of the debt by the end of the term.
The cost of an interest-only mortgage
Let’s say you borrowed £160,000 to buy a £200,000 home, at a 3.7% APR over a 25 year term.
The annual interest on this is £5,920, so this will be how much you will have to pay to the lender each year on an interest-only mortgage. On a full repayment mortgage you would pay this on top of a small repayment of the debt.
Interest-only Monthly payments would be around £493 and the total you’ll pay over 25 years is £148,180, plus you would still owe £160,000. So the lifetime of the mortgage will cost you £308,180.
Full-repayment Your monthly payments would be £818, over 25 years you’ll pay £245,479. So an interest only mortgage would cost you £62,701 more in the full term and if you do not have repayment vehicle you would also have to sell your home too.
Who can get an interest-only mortgage?
To avoid borrowers being caught out (and unsustainable debt), the Financial Conduct Authority (FCA) require that a lender can only provide an interest-only mortgage if there is a credible plan on how to repay the debt at the end of the term, such as an ISA or other investment fund.
Your income and spending are very strictly assessed to determine whether you can afford the mortgage, specifically if you could cope if interest rates rise.
What are interest-only mortgages used for?
Buy-to-let mortgages are typically interest-only. Lenders take the potential rental income into account when determining mortgage affordability.
Buy-to-let mortgages are considered to be a business loan though and are not regulated by the FCA in the same way as residential mortgages.
In some areas with high rent prices, taking out an interest-only mortgage could be cheaper than renting. Whilst it is unwise as a long-term arrangement it is a way to get on the property ladder, although it is advisable to switch to a repayment mortgage as soon as possible to pay back debt.
A riskier option to take is to gamble on house prices rising. You could sell, pay off your mortgage debt and potentially make a profit.
Should house prices fall though you end up owing more than your home is worth and risk defaulting on your mortgage.
Using any form of risk-based investment – be this the value of your property, or other investments – to buy your home should be considered carefully, as you could end up with insufficient funds at the end of your interest-only mortgage term.