What is an interest-only mortgage?
There are two types of mortgage payment methods. One is known as a repayment or capital and interest mortgage, the other is known as an interest only mortgage. With a repayment mortgage, the borrower repays each month the interest that they owe on the capital amount that they have borrowed from the lender and a portion of the capital amount itself.
An interest-only mortgage is a loan for a property that allows you to pay off just the interest on your borrowing each month, and not the capital.
This means your monthly payments don’t pay off any of the loan.
With a repayment mortgage, as long as you maintain your repayments for the duration of the loan term, you will repay all of your borrowing in full by the end of the mortgage term.
With an interest-only mortgage, the size of your mortgage borrowing debt stays the same throughout the mortgage term, unless you choose to make additional payments, over and above the expected interest payments, to reduce the capital amount that you owe. You will be expected to repay the borrowing at the end of the mortgage term and lenders will wish to confirm what your plan is for doing so before offering you an interest only mortgage.
Why consider an interest only mortgage?
The main reason that borrowers consider interest-only mortgages is that the monthly mortgage payments will typically be significantly lower than if the same amount of money was borrowed on an the equivalent basis but on a repayment mortgage basis. With an interest only mortgage, however, your monthly payments won’t help you reduce your debt. This makes interest-only mortgages more risky, as they require borrowers to save or invest enough during the course of their mortgage term, to be able to pay off the full amount at the end. As a result, lenders impose additional restrictions on borrowers seeking to borrow on an interest only basis, over and above those required for lending being sought on a repayment basis.
Interest only mortgages do, however, suit some borrowers:
- Where the income of borrowers is irregular (such as where a client is self-employed or where irregular and unpredictable bonus or commission income is a part of their income) interest only mortgages can help the borrower manage their monthly outgoings by keeping the required monthly mortgage payments low. In this circumstance interest only borrowers sometimes repay the borrowing before the end of the mortgage term by making ‘lump sum’ payments when they receive, for example, a bonus. Restrictions may apply as to how much of the borrowing can be repaid in any one particular year via lump sum repayments.
- Where applicants wish to keep monthly payments low and know that they will be able to repay the borrowing at the end of the mortgage term as they know that they will have sufficient funds available as the result, for example, of personal savings to repay the mortgage borrowing.
- Where borrowers plan to sell their home at the end of the mortgage term, downsize to a smaller home and repay the borrowing with the equity that will be available once the sale of their existing home is completed.
- Where borrowers wish to borrow partly on an interest only basis and partly on a repayment basis (known as ‘part and part’ mortgages) in order to keep their monthly payments lower than if they were to borrow on an equivalent repayment basis.
- Where a borrower is borrowing to invest in a buy-to-let property and is intending to sell the property in order to repay the borrowing and keep their monthly costs as low as possible, then they will often require an interest only mortgage.
- Some lenders offer interest-only mortgages specifically designed for people in or nearing retirement. You might see these referred to as ‘RIO mortgages’. These can be a suitable option for people who are nearing the end of an existing interest-only mortgage term, do not wish to sell their home and are unable to repay the loan in a different way. They can also suit those who are looking to release some equity from their property without taking out an equity release product.
Who can get an interest-only mortgage?
You can get an interest-only mortgage on a residential or buy-to-let basis; however, the lenders lending criteria might mean this isn’t a viable option for you.
Lenders may have more strict restrictions on who they will lend to on an interest only basis, based on the borrowers:
- Income – some lenders may require a higher income for interest only borrowing when compared to the level of income required for borrowing on a repayment basis
- Loan-to-value – lenders may only lend a smaller proportion of the property value if the borrower is borrowing on interest only basis
- Term – lenders may lend for a shorter overall mortgage term than they will do for a repayment mortgage
- Equity – lenders may require a minimum amount of equity in a property before they will consider lending on an interest only basis
- Repayment method – lenders will require that the borrowing be repaid at the end of the mortgage term. Different lenders will allow borrowers to have different plans for the repayment of the borrowing. Some lenders will allow the sale of the mortgaged property as the repayment plan and others will not, for example.
Each lender will have their own specific criteria that borrowers will have to meet before they are willing to consider lending on an interest only basis. The above list is not an exhaustive list of the criteria that a lender will consider. Our advisors will be able to discuss with you, in detail, whether an interest only mortgage is one that might be suitable for your circumstances. We certainly advise discussing this option with a mortgage advisor before deciding whether it is suitable for you. Please get in touch with us, if you wish to discuss this mortgage option further.
