Interest Only Mortgages

Do you find it difficult to make your mortgage payments because of high-interest rates? Is moving to an Interest Only mortgage an option for you? You might be considering whether this is a suitable method to save money and shield your finances from the effects of rising interest rates. 

In this insight, we'll look at the possibility of switching to an interest only mortgage and how that could help you save money when interest rates are high. Before we go into detail, we need to understand how interest-only mortgages work.

Key Takeaways

• An interest only mortgage is a type of mortgage where the borrower is required to pay only the interest portion of the loan.
• At the end of the interest only period, the borrower is required to begin making payments that include both the principal and the interest.
• Interest-only mortgages can result in lower monthly payments, but the total cost of the mortgage will be higher since the principal amount is not being paid down.
• Interest-only mortgages can be risky for borrowers who do not have a plan to pay off the principal balance, as they may end up owing more than the property is worth or facing higher payments later on.

What is an Interest Only Mortgage?

An Interest only mortgage requires only making monthly payments each month that are made up only of the interest due the lender. This means that the monthly payments are less overall than they would be with a standard repayment mortgage. Repayments are lower because there is no capital being repaid on the loan, the loan does not go down, and only the Interest is paid each month. 

At the end of the Mortgage term, the borrower still must repay the full capital amount. This differs from a repayment mortgage, where the full mortgage is cleared by the end of the term.

Mortgages with interest only payments involve dangers, but they can also allow borrowers more freedom and cheaper monthly payments.

What Are The Risks of an Interest Only Mortgage?

• The borrower is not building equity in their home during the interest-only period.
• The monthly payments are lower during the interest-only period, but they will increase after the period ends.
• If the value of the home does not increase or the borrower needs to sell before the interest-only period ends, they may not have enough equity in the home to cover the loan balance.
• If the borrower is unable to make the higher payments after the interest-only period ends, they may face the risk of default or foreclosure.
• Interest-only mortgages can be more difficult to qualify for and may come with higher interest rates and fees compared to traditional mortgages.

Example of Interest only repayments

If you have a Mortgage of £200,000 on interest-only terms, you will only pay the interest each month for your payments. 

Using an interest rate of 3% and a term of 25 years your payment would be:

£200,000*3% = £500 a month. At the end of the Mortgage term, £200,000 would still be outstanding.

Repayments for this mortgage including capital would be £948. At the end of the Mortgage term, the mortgage should be repaid in full.

Interest Only Mortgage Eligibility

In general, interest only mortgages can be more difficult to qualify for compared to traditional mortgages. This is because interest only mortgages carry some additional risks for the borrower and the lender.

For the borrower, the risk is that they will not have enough equity in the home to repay the loan after the interest-only period ends unless they have the plan to Remortgage to repayment terms or make a lump sum payment. 

For the lender, the risk is that the borrower may default on the loan if they are unable to make the higher payments after the interest-only period ends.

As a result, lenders may have stricter eligibility requirements for interest-only mortgages, such as a higher credit score or a larger down payment. In addition, interest-only mortgages may come with higher interest rates and fees compared to traditional mortgages. Borrowers who are considering an interest-only mortgage should carefully compare their options and choose a loan that is right for their financial situation and goals.

What is a Repayment Vehicle for an Interest Only Mortgage?

A repayment vehicle for an interest-only mortgage is a method or plan for repaying the loan after the interest-only period ends. Lenders will assess how viable your repayment vehicle is, and require evidence when deciding whether you are eligible for interest-only terms or not.

A repayment vehicle could include a lump sum payment, such as the sale of another property or investment, or a refinancing plan. 

Acceptable Repayment vehicles for interest only mortgages

Borrowers who are considering an interest-only mortgage should carefully consider their repayment options and choose a repayment vehicle that is right for their financial situation and goals.

Pensions as repayment vehicles

You are able to take 25% of your pension tax-free if you are over 55. It may be possible to use your pension as a repayment vehicle. However, lenders will decide within their own policies how much of your pension is considered allowable as a repayment vehicle. For example, they may determine only 15% of your pension pot could be used.

Sale of a second property as a repayment vehicle

If you have a second property, it can be valued by your lender and the equity can go toward your repayment vehicle.

Sale of the Mortgaged property as a repayment vehicle

You can utilise the proceeds from the sale of the house when the loan's term is up to pay off the debt. However, there is a chance that declining house values may force you to make up a shortfall. This is more commonly available for repayment vehicles for buy-to-let mortgages, than residential.

Equity investments or stocks and shares (including ISAs) as a repayment vehicle

If you have investments, this can be a straightforward strategy to use, but each lender will take a different approach how to assess your investments and this can make a difference to eligibility.

Endowment policies

Some lenders still consider endowment policies as acceptable repayment vehicles. 

Can you get an Interest Only Mortgage without a Repayment vehicle?

At the moment it is not possible to get an interest-only mortgage without a repayment vehicle.

However, the FCA have been meeting to determine what methods are appropriate for helping borrowers who may be feeling the pinch. Watch this space to see how these meetings unfold over the next few months and whether rules are relaxed, as expected by many.

Financial difficulties and interest only

If you are experiencing financial difficulties and cannot make your repayments, due to interest rate increases, you can speak to your lender. There may be alternative solutions to assisting, such as increasing your mortgage term or temporary repayment holidays. 

It is not out of the question that a lender would look to every option possible before considering repossession. In times of financial difficulty, your current lender may consider a short-term interest-only agreement.

Switching to an interest only Mortgage

In summary, it is possible to switch to interest only, however, a suitable repayment vehicle is required. If you are looking to make this move, your best option is to speak to a Mortgage adviser who can advise from a panel of lenders.

A mortgage adviser will have an understanding of the lenders' policies and this will give you the best chance of finding a lender who will accept your application, based on your needs.

For more reading, consider: Do Banks Still Offer Interest Only Mortgages?

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