The world of mortgages can be a little confusing to navigate, especially for first-time buyers. There are so many options available to aspiring homeowners that it can be challenging to know which one to go for. Here, we are going to explore interest-only mortgages. These have gained in both popularity and controversy in recent years, so let’s take a look at the advantages and disadvantages, as well as who is eligible for them.
What is an interest-only mortgage?
If you take out an interest-only mortgage, you simply pay the interest on the amount that you have borrowed each month – that is it. Until the mortgage term has ended, you don’t have to pay the full amount back. This is different from a normal repayment mortgage, where you pay for both some of the loan and interest every month, which brings the debt down gradually until at the end of the mortgage term and you have paid it off fully.
Why choose an interest-only mortgage?
Not everyone is suitable for an interest-only mortgage, and it is vital that you are aware of all of the risks that come with this type of mortgage. They might be an option if you have a solid plan for saving the money for the eventual repayment or know for sure that you are coming into enough money to pay for it, such as a large windfall or inheritance payout.
How do interest-only mortgages work?
During the term of the mortgage, you will pay interest on a monthly basis. The term can be just a few years or a long term, such as 20 years. Once the mortgage term is over, you will still owe your mortgage lender the same amount of money that you originally borrowed, so at that point, you either need to make a full repayment or remortgage your home. Many lenders will insist on seeing proof that you have the means to pay off the full mortgage amount at the end of the term, such as an ISA, investment, or endowment policy. This is what is known as a repayment vehicle.
What are the advantages of an interest-only mortgage?
Many people want to be able to start off with lower payments and increase them when they have a higher income or more savings towards the end of their mortgage term.
- The monthly payments on an interest-only mortgage are significantly lower than a traditional repayment mortgage, as you are only paying the interest on the loan.
- If you have investments and they work well or better than expected, you may be able to pay off the mortgage faster than with a repayment mortgage without selling or taking out a new mortgage.
- If you are expecting to come into a large sum of money – enough to cover the full cost of the loan – in the future, taking out an interest-only mortgage means that you can buy the property now and pay off the cost of the purchase when the mortgage term has finished.
What are the disadvantages of an interest-only mortgage?
The pressure of knowing that at the end of the interest-only mortgage term, you have to pay the initial loan in full is one of the biggest disadvantages of an interest-only mortgage.
- You will typically pay more overall in interest than on a standard repayment mortgage, as the amount that you are paying interest on is not decreasing during the term of the mortgage.
- You are only ever paying off the interest, so at the end of the term, you will still be liable for the full amount.
- You have to look after your repayment vehicle (ISA, investments, inheritances, endowment policies etc) as well as the mortgage.
- If you are relying on things like investments, rising house prices, pension funds or inheritances, you may end up not having enough money to pay it off at the end.
- If you want to pay off your interest-only mortgage early, you may be charged early repayment fees if you are on a fixed rate, as you would with a repayment mortgage.
Criteria varies from lender to lender, although will generally be stricter across the board in the case of residential purchases.
Lenders will typically expect you to meet the following requirements:
- Income and affordability – you’ll need to prove that you can afford the repayments, and, in many cases, that you have an income in line with the lender’s minimum income threshold for this mortgage type.
- Credit history – your credit rating will be less impactful to the outcome of your mortgage application than it would for a capital repayment mortgage, especially in the case of buy-to-lets. However, serious credit issues could still be a stumbling block.
- Age – Most lenders have minimum and maximum age thresholds, although some interest-only mortgages are intended specifically for older borrowers, such as a RIO (Retirement interest-only). There are also some lenders with no maximum age requirement.
Interest-only mortgages are a great option for some potential homeowners, although it is important for you to get advice from a professional mortgage advisor who can tell you whether it is the right choice for you.
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