What Is An Interest-Only Mortgage?

With an interest-only mortgage, the borrower pays only the interest on the loan each month. Then, they must repay the total amount borrowed at the end of the loan period. This type of mortgage means borrowers will pay less each month. While this is a major benefit of interest-only mortgages, they are not suitable for everyone. 

Read this guide to find out more about interest-only mortgages in the UK, how they work and what the advantages and disadvantages of these are. Finally, discover if an interest-only mortgage is a good idea for you. 

How Does an Interest-Only Mortgage Work?

If you take out an interest-only mortgage to buy your property, you won't need to pay back the money borrowed until the loan period ends. Each month, your monthly payment will only cover the interest charges on your loan. If you apply for an interest-only mortgage you will still owe the lender all of the original capital borrowed at the end of the loan term.

Interest-Only Mortgages Vs. Repayment Mortgages

If you have a repayment mortgage, you will need to pay back a percentage of the loan amount plus interest each month. Most UK lenders calculate the monthly instalments using a compound interest calculation. As such, if you meet your repayments, the loan is paid off by the end of the term, and you no longer owe the lender.

In contrast, if you have an interest-only mortgage, you only pay the interest each month. Therefore, you still owe the total of the sum borrowed when you reach the end of the term!

What Are the Advantage of Interest-Only Mortgages?

The primary advantage of having an interest-only mortgage is that you only pay the interest! This means that your monthly payments are much cheaper and less of your salary needs to go towards the mortgage. Let's run through an example: An interest-only mortgage of £185,000 taken out over 25 years at a 3.25% interest rate would require a borrower to pay £501.04 to the lender each month. However, a repayment mortgage would require a significantly larger monthly payment of £901.54.

What About the Disadvantages? 

On the other hand, you must not forget that you will end up owing the full amount borrowed at the end of the loan term. Using an interest-only mortgage will make monthly payments more affordable, but you will have to make a large lump sum payment down the line.

As per our example, you will need to pay £501.04 each month for 25 years, but you'd still owe the lender £185,000 at the end of the loan term.  Although the monthly payment is higher with a repayment mortgage, you owe nothing and own the property outright by the end of the period.

A qualified mortgage broker will use a mortgage calculator which compares mortgages from many building societies, banks and specialist lenders. They will also advise on the options available including interest-only and repayment mortgages you finally opt for, you must remember that your home may be repossessed in the event of you being unable to make repayments.

What If I Can’t Pay Off My Interest-Only Mortgage? 

Being unable to afford a mortgage is often a significant concern for homeowners with an interest-only mortgage. If you find yourself in this position, you may need to sell your house or take out a new mortgage to stop your home from being repossessed. If you think you won't be able to afford to repay your mortgage, seek financial advice as soon as possible. 

How to Repay an Interest-Only Mortgage

If you've used an interest-only mortgage to help you buy your property, here's some advice on paying back the capital. Consider switching your type of mortgage to a repayment plan mortgage or setting up an investment plan to ensure that you'll be able to repay the amount you owe at the end of the mortgage term.

1. Switch to a Repayment Mortgage

Some people choose to switch their interest-only mortgage to a repayment one. Doing this will increase your monthly payments, but you no longer have to stress about repaying the entire borrowed sum at the end of the term. If you are concerned about the increase in monthly payments, look for an option to repay over a more extended period. It's even possible that you'll find a better mortgage rate available, saving you money. 

2. Pay Into an Investment Plan

If you are going to stick with your interest-only mortgage, consider paying into an investment to accumulate funds. At the conclusion of the mortgage period, you can utilise this to settle the balance due. Consult with a financial expert to discover a plan that is appropriate for you.

Alternative Ways to Pay for an Interest-Only Mortgage

While your initial plan might be to repay your interest-only mortgage by cashing in an endowment policy, it may be that the endowment fund has not performed as well as expected and there is a shortfall. 

There are also a number of people who have had to cash in their endowments or savings to pay for unexpected bills or haven’t been financially astute enough and been tempted into cashing them in for non-essential things such as holidays. This being the case, depending on your circumstances you might be able to:

• Sell a second property (buy to let or holiday home) or another asset such as a classic car in order to clear the shortfall.
• Downsize by selling your home and buying a less expensive property and using some of the equity to cover the shortfall. A number of people sell their property as a way of releasing cash. While they may have had a 5-bedroom home to bring up their young family, once the children have left home it makes sense to move to a smaller property, perhaps a 2 or 3-bedroom property.
• Once you reach the age of 55 you are able to withdraw up to 25% of your pension fund tax-free. This may be a solution to pay any potential shortfall. 

Again, as long as you and your partner are both at least 55, you may be able to consider a lifetime mortgage. An equity release plan allows you to borrow an amount secured against your home. The interest rate is fixed and you don’t make any repayments. The amount outstanding rolls up each month until the loan is repaid which would be when you pass away or move into long-term care at which point the property is sold to repay the loan.

The Second Mortgage Company strives to simplify the process for you and offers assistance throughout. If you're seeking to consolidate your debts through a second mortgage, we encourage you to reach out to us today.