Over recent years, the term ‘Interest Only Mortgage’ seems to crop up more and more – but what does it mean?
An interest only mortgage is when solely the interest is the payment being made on the mortgage. Let’s break this down. Mortgage payments are made up capital and interest. When the interest is primarily being paid during the mortgage term; this will mean that the payments do not cover the loan – hence why the capital needs to be paid at the end of the mortgage term or in one lump sum.
The maximum term for interest mortgage is only 25 years which is why it is so significant borrowers understand that it is their responsibility to ensure their mortgage is repaid in full at the end of the term by ensuring they have a repayment strategy in place.
Why would you want to get an interest only mortgage? Well for one, the main advantage to interest only mortgages are the lower monthly payments. This is due to the mortgage payments only covering the interest and not the capital. This gives less of a chance for an individual to fall into arrears.
For a mortgage loan of £160,000, with a 4% interest rate. It would cost:
Type | Total Cost | Interest Paid |
Repayment | £252,316 | £92,316 |
Interest Only | £326,175 | £166,175 |
Repayment mortgages do cost less overall however the monthly payments are higher in comparison to interest only mortgages. For example, the above mortgage would cost:
In addition to lower monthly payments, there is the flexibility to decide where your money goes. If you have any extra money this could be put forward towards overpayments. The over overpayments would come straight off the capital debt. Typically, overpayment allowances tend to be 10%.
Additionally, there is potential to make profit if your investment performs successfully. You could save up enough funds to pay off the mortgage balance in a much shorter term or keep a lump sum to purchase something else.
With interest only mortgages, throughout the mortgage term the size of the debt will remain the same. This differs from a repayment mortgage, where both capital and interest are paid simultaneously each month. This will allow an individual to chip away at their debt so by the end of the term, the original sum borrowed is fully repaid.
For example, on a £250,000 interest-only mortgage which charges 3% over a 25-year term – the monthly mortgage payment would be £625. This would equal to £187,500 after the 25-year period. However, you would also have to pay back £250,000 at the end of the mortgage agreement.
With a capital repayment mortgage if you borrowed £250,000 with the same conditions – your monthly mortgage payments would be £1,186 and the capital would be cleared at the end of the term. Under these terms, you would pay £105,800 in interest which would make this £81,700 cheaper than the interest only mortgage.
It is important to note that when the loan matures, the capital will have to be repaid. Hence why, borrowers should ensure a savings vehicle is in place to produce money for when the capital is due.
A viable way to pay off the capital is to cash in on any investments and savings you may hold. Several people use the tax-free lump sum from their pension to repay the outstanding capital. However, keep in mind, this will impact your retirement income.
In addition to this, making overpayments alongside your interest payments is a good way to reduce your debt. Most lenders will allow you to repay upto 10% of the outstanding mortgage annually before incurring any early repayment charges (ERC). Check the terms of your agreement to ensure you are adhering to the conditions.
Moreover, some borrowers choose to sell their property; especially if their market value has appreciated in value. If you have built up a decent amount of equity, then you could potentially use this to also purchase another home.
Under the conditions of most interest only agreements, failure to repay the capital after maturity can result in repossession of your home. In recent years, the Financial Conduct Authority (FCA) has instructed lenders that they must treat all borrowers fairly and allow them time to consider their options.
If you are worried about paying off the capital, there are different ways to do so:
As mentioned above, there are various options to opt for once your loan reaches maturity. Paying off the capital is required and part of the conditions of an interest only mortgage.
To recap some of these include:
It is possible to attain an interest only mortgage through a residential or buy-to-let basis. However, the lending criteria may not be favourable for first time buyers as large deposits are typically required.
To be eligible you must ensure you have a substantial deposit – loan to value requirement is typically 50-60% meaning that your deposit should cover 40-50% of the property’s value.
Some lenders will also require you to earn a minimum income amount, for example Nationwide requests sole applicants must earn at least £75,000 to adhere to their lending criteria.
In addition to this, all applicants must need to provide a clear plan on how they are going to repay their capital at the end of the mortgage term.
If you’re looking to arrange an interest only mortgage, speak to one of our award-winning brokers by calling 0800 32 88 680 today.
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