What are Interest only mortgages?
Interest only mortgages are mortgages for which you only pay the interest that has accrued on your home loan each month. With a traditional repayment mortgage you pay the interest and you repay part of the capital (the lump sum you borrowed to buy your property). This means that at the end of the mortgage term you will have repaid your loan in full. When interest only mortgages come to the end of their term you generally still have the entire capital amount outstanding which then has to be paid via some other means.
Traditionally, interest only mortgages were always sold alongside another product such as an endowment policy. This is a product which you pay into monthly which then invests that money in the stock market, with the aim being that when your mortgage term ends your endowment policy will be worth enough to cover the capital outstanding on your mortgage. Nowadays, particularly since the boom in property prices, some people have been taking out interest only mortgages without having any real plan in place as to how they are going to repay the loan.
What are the pros and cons of interest only mortgages?
Pros of interest only mortgages:
Interest only mortgages allow you to get on to the property ladder if you cannot afford to make the larger monthly payments of a repayment mortgage. When you become a bit more financially secure you can than remortgage to a repayment mortgage and start paying off the capital.
In areas such as London and South East where property prices are particularly high interest only mortgages can be a good option because they can actually work out cheaper than renting. But again, you should always try to either switch to a repayment mortgage as soon as you can or make sure you have some other robust payment plan in place.
Interest only mortgages can also be great for those borrowers who don’t receive a good chunk of their income as a guaranteed salary. This could be because they are self employed and don’t have a regular income or maybe they are employed but depend on bonuses or overtime to make up their salaries. In these cases it is a good idea to get an interest only mortgage that has some flexibility. Meaning, one that allows you to make over payments in good months.
Some lenders will allow you to take out a part interest-only and part repayment mortgage, allowing you to gradually reduce the interest only portion.
The other thing to bear in mind is the borrower’s situation. A lot of buy-to-let investors take out interest only mortgages because they intend to sell the property eventually. They will never need to live in it but just hope to profit from it either through an increase in property prices or buying receiving rent over and above the interest payments and any other costs.
Cons of interest only mortgages:
An interest only mortgage will cost you more in the long run because you don’t pay off any of the capital throughout the course of the mortgage – you are paying interest on the entire amount for the whole time. With a repayment mortgage your monthly payments start off being made up of a lot of interest and a little capital repayment but the balance gradually shifts until you are mainly repaying capital with a little interest.
Some people would rather take a chance by taking out a bigger property loan and just paying the interest on it in the hope that property prices increase enough so that they gain more from the increase than they lose in extra interest payments.
As lenders see interest only mortgages as riskier than repayment ones they may demand bigger deposits than required for the equivalent mortgage on a repayment plan. Or they may just charge a higher interest rate on interest only mortgages. At the time of writing, the Halifax has recently introduced interest rates which are 0.2% higher for interest only loans.
If you are thinking of going down this route then look at the maths in detail. Speak to a professional mortgage advisor who will help you determine whether interest only mortgages are a suitable option for you by talking you through the possible pitfalls and helping you to put in place a realistic repayment plan.