When applying for a mortgage you will need to tell the lender how you intend to repay it.
There are 2 options:
- Repayment mortgage
- Interest only mortgage
Here we will look at interest only mortgages. What they are and how they work.
What is an interest-only mortgage?
An interest only mortgage is a type of mortgage where you only have to pay the interest each month.
The monthly payments are cheaper than a repayment mortgage. However, at the end of the mortgage term the debt which needs to repaid is the same as you initially borrowed.
How do they work?
With an interest only mortgage you do not have to make any repayments of capital each month. The lender is only expecting the interest, not any of the original debt.
So as each year of the mortgage term passes your outstanding mortgage amount stays the same.
The chart below shows how the mortgage balance changes each year.
One of the biggest benefits is that the monthly payments are considerably lower than a repayment mortgage. This makes them much more affordable but there still needs to be a plan for eventual repayment.
Here’s a quick example showing the different monthly payments for the same initial mortgage.
£200,000 borrowed over 25 years at 3.50%
|Repayment method||Monthly payment|
How do you repay an interest only mortgage?
For most residential mortgages the lender is looking for a definite plan of how this will be achieved. They will be more relaxed for buy to let mortgages and bridging loans as these don’t involve your main residence.
Some time ago endowment mortgages were popular. This involved an interest only mortgage and an endowment savings plan. The basic idea is that the endowment investment would grow large enough to pay off the mortgage. It is no longer possible to take out an endowment mortgage.
There are a few ways that an interest only mortgage can be eventually be repaid. Each lender has their own rules on whether they deem these suitable.
Some options are:
- Sale of the property (downsize)
- Sale of another property
- Equity release
- Savings plans
The sale of interest only mortgages now involves a few more rules and checks by the lender to ensure there is a solid plausible plan for repayment.
Advantages and disadvantages of interest only
They are considerably cheaper each month when compared to a repayment mortgage. As there is no fixed repayment structure you could make adhoc repayments during the term to gradually reduce the debt when money becomes available. Most landlords choose to have interest only buy to let mortgages as their income yield is greater.
The main disadvantage is that over the whole mortgage term you will pay more interest than a repayment mortgage. You also need to be quite disciplined to keep up with any investment savings that are needed to accrue for repayment and the end of the term.
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