How Does an Interest-Only Mortgage Work?
Estimated reading time 7 minutes
When you opt for an interest-only mortgage your monthly payments exclusively cover the interest charged by your lender on the initial loan amount borrowed to purchase your home. None of the money you pay reduces the original loan amount you borrowed. That’s right, the balance you owe doesn’t go down, it remains the same and you are only ever paying off the interest. So, you need to have a plan in place to pay off the balance (full amount you borrowed) at the end of the mortgage.
Interest Only vs Capital Repayment Mortgage
Let’s do a side-by-side comparison of an interest-only mortgage and capital repayment mortgage. With an interest only mortgage you only pay the interest on the loan, this means your monthly payments will be much lower than that of a capital repayment mortgage. As the amount you borrowed never goes down you will end up paying more interest in the long run, so although the monthly payments are lower over the entirety of the mortgage you will pay back more.
If you take out a repayment mortgage, your monthly payments will be set to repay the money you borrowed as well as the interest charged over the lifetime of the mortgage. Your monthly mortgage payments are set to cover not only the interest but also the loan. By the end of the mortgage term if you have made all your payments, you will have paid off all the money you owe. the amount you pay each month will be higher than an interest-only mortgage but as the years go on the amount you owe will be reducing and at the end of the term you owe nothing.
A Mortgage Calculator example
(for this example we are assuming no arrangement fees and interest rates staying the same)
Mortgage Debt = £200,000
Interest rate = 5.75%
Mortgage Term = 25 years
Interest-Only Mortgage per month you pay = £958
Capital Repayment Mortgage per month you pay = £1,258
Total you’ll repay over full term of the interest only mortgage = £487,310
(mortgage debt £200,000 + total interest £287,310)
Total you’ll repay over full term of the capital repayment mortgage = £377,325
(mortgage debt £200,000 + total interest £177,325)
Why Choose an Interest-Only Mortgage?
Here are some reasons why you might consider an interest-only mortgage:
1. Lower Monthly Payments: As you are only paying the interest charges on the amount you borrowed, your monthly payments will be lower than those for a repayment mortgage. So, if you’re looking to free up some cash with the intention of making renovations or if you are anticipating an increase in financial obligations and interest-only mortgage could be an attractive option for you.
2. Investment Opportunities: Some borrowers choose an interest-only mortgage because it allows them to make an investment elsewhere. The money they would have used for principal payments could instead be used to generate a higher return that the interest rate of the mortgage.
3. Short-Term Solution: If you are expecting an inheritance or a bonus and intend to pay off a lump sum it may financially make sense to use an interest-only mortgage as this can serve as the lump sum repayment. If you are planning to sell your property in the near future an interest only mortgage allows you to keep your monthly payments low over this timeframe.
4. Flexibility: An interest-only mortgage provides flexibility in managing your finances. During the initial period, you have the option to make additional principal payments if you can afford to which can help reduce the overall interest charges and shorten the term of your loan.
Pros and Cons of Interest-Only Mortgages
So when might you want to switch your repayment mortgage into an interest only mortgage.
- Reducing Monthly Expenses – if you are experiencing difficulty making your monthly mortgage payments switching to an interest-only mortgage can provide some financial respite.
- Buy-to-let – if you are a landlord an interest-only mortgage allows you to put aside profits to pay back the full capital. Check out our guide is buy to let still it for landlords or investors.
- Investment Opportunities – if you have identified an investment opportunity that requires additional capital, moving to an interest-only mortgage can free up cash for your investment.
- Short-Term Ownership Plans – if you are thinking of selling your property in a few year switching to an interest-only mortgage can help you manage your finances more effectively over this time. It could be a good option if you want to free up some cash to do renovations quickly so you can sell the flat fast.
- Desire for Financial Flexibility – If you value financial flexibility and want the option to make larger principal payments when it suits you, an interest-only mortgage might be a good fit.
Those are the obvious pro’s of an interest-only mortgage now let’s look at the con’s
- Balloon payment: During the interest-only period, you’re not reducing the principal balance of your loan. This means at the end of the term you still owe the original amount you borrowed and will potentially have to make a substantial lump sum payment
- Property Value: If your property value decreases you may end up owing more than your property is worth when it comes time to sell or refinance
- Higher Total Interest Costs: Over the life of the loan, you may end up paying more in interest compared to a traditional mortgage. This is because you delay principal repayment.
- Potential Payment Shock: When the interest-only period ends, your monthly payments can significantly increase, catching some borrowers off guard. Be prepared for this financial transition.
- Risky Investment Strategy: Using an interest-only mortgage to invest can be risky. Investments are subject to market fluctuations, and there are no guarantees of returns.
- Limited Lender Options: Not all lenders offer interest-only mortgages, and eligibility requirements can be stricter. You may need a strong credit history and a larger down payment than is required for a repayment mortgage.
For further details on Mortgages check out our Mortgage Guide.
How to Repay an Interest-Only Mortgage?
Choosing an interest-only mortgage depends on your financial situation and circumstances and you must have a plan in place as to how you will repay the principal. Here are few ways to repay an interest-only mortgage:
- CHANGE TO REPAYMENT MORTGAGE: If you don’t want to sell your house you need to consider other options, you can change some or all of your interest only mortgage to a repayment mortgage.
- OVERPAYMENTS: You could make overpayments, these are lump sums that are paid to bring down the balance and reduce the amount of interest you’ll be charged, you can stop and start them and change the amount whenever you like. Do check the mortgage terms to see how much you can overpay each year without being penalised.
- LIQUIDATE ASSETS: You can sell investments, pensions, endowments, savings, ISA’s, shares and other properties you own can be sold to help pay off some or all of your mortgage balance. Speak to an independent financial advisore to make sure liquidating assets is the right course of action for you.
Is an Interest-Only Mortgage Right for Me?
Weigh up the advantages against the disadvantages and seek advice from a financial advisor and your lender before making any decisions as it is important to have a plan in place for the repayment and that you fully understand the benefits and potential risks of an interest-only mortgage.
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