If you’ve ever had a mortgage, or know someone who has, you may have heard of an interest-only mortgage.
An interest-only mortgage is a type of mortgage in which, unlike a traditional mortgage where you reduce the balance with your payments and pay interest as well, you only pay the interest.
How do they work?
With a traditional capital and interest mortgage, your monthly payments go toward reducing the principal (the balance of the mortgage) and paying the interest (the cost of borrowing set by the lender).
With an interest-only mortgage, you are only paying the interest, meaning the total mortgage balance will remain the same throughout the mortgage term.
What is the benefit of an interest-only mortgage?
Interest-only mortgages are not as popular as they once were, making up only around 9% of mortgage types in the UK in 2023. They can be beneficial in that they usually come with a cheaper monthly premium, as you are only paying the interest on the mortgage and not the actual balance.
What’s the point?
This type of mortgage is commonly used for buy-to-let properties, where the landlord wants to keep monthly payments as low as possible to maximize the income generated from rental payments.
What are the drawbacks of an interest-only mortgage?
As you are only paying the interest and not the capital, the balance remains the same throughout the term. Therefore, when the mortgage term ends, the bank expects you to be able to repay the full mortgage.
With rental properties, this isn’t much of a problem, as you can always sell the property to repay the mortgage. However, with a residential property, like your home, this would mean having to sell your home to repay it, unless you had the money available.
If your property were to reduce in value over time, this could also result in negative equity, meaning even the sale of the property would not cover the mortgage, and you would have to find the remainder of the balance elsewhere.
Why are they not as popular?
Due to the nature of an interest-only mortgage, where you have to repay the loan in full at the end, many people who took out this type of mortgage many years ago on residential properties to benefit from low payments are now coming to the end of their term. They may have to sell their home to repay the mortgage or find the cash.
Another option is to remortgage and switch the interest-only mortgage to a capital repayment mortgage. However, for many people in their late 50s or 60s at the end of the term, this leaves them with a window of 10 to 25 years to repay the new mortgage, as most lenders’ maximum lending ages are 70 to 75.
With such a relatively small window, and the loan most likely still being quite large as it hasn’t reduced over the years, the monthly repayments would be much higher, potentially too high to be affordable for customers. This could affect their lifestyle and cost of living, or even worse, result in the forced sale of their home.
How do I get one?
Most lenders will offer interest-only products on buy-to-lets, but with residential mortgages, you will need to meet certain criteria, such as having enough equity in your property, a sufficient income, and being within an acceptable age range.
An interest-only mortgage may not be the right product for you, so it’s always best to speak to a mortgage adviser before deciding which route to take.
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