My Guide To Interest Only Mortgages
It can be a daunting prospect when it comes to choosing a mortgage, especially since it is a fairly large financial commitment to make. It is important to understand what you are getting yourself into. Today, I want to talk about interest only mortgages. Although these mortgages are becoming less common, there are still situations where they can be the right choice.
Interest only mortgages are a much higher risk than a traditional repayment mortgage since in the majority of cases the repayment vehicle that is intended to cover the repayment of the capital borrowed is not guaranteed. Like all investments, there is no telling whether or not they will grow as intended.
“The value of pension and investments can fall as well as rise. You may get back less than you invested.”
Introduction to Interest Only Mortgages
What Is An Interest Only Mortgage?
When taking out an interest only mortgage, only the interest is repaid to the lender. The original capital is not included in the agreed repayment, meaning that you must arrange an alternative way to pay back this amount. Some of the repayment methods include overpayments, ISA, endowment and other options, all of which are outlined below. It is important to seek advice from a financial adviser regarding the suitability of any repayment vehicle.
Repayment Methods Explained
Endowment & ISA
One of the most common choices for arranging the repayment of your capital at the end of an interest only mortgage is to set up some form of ‘repayment vehicle’ which is an investment running alongside the mortgage. This investment might take the form of an endowment policy or an ISA. The risk with this type of investment is that there is no guarantee that it will perform well enough to allow you to repay the capital.
With many personal pensions, it is possible to withdraw up to 25% of the fund on reaching retirement age. This can be taken as a tax free lump sum which is perfect for paying off the capital owed on an interest only mortgage. However, this depends on this sum being large enough and with all investments, there is always a risk that the fund will not perform as well as expected.
Those who know that they are due a substantial inheritance may choose to use this lump sum to repay the capital on an interest only mortgage. This is a great choice if you know exactly when the inheritance is coming – for example a trust fund that is released when you turn thirty. However, if it is money that will be inherited following the death of a relative,then that is not something that can be planned according to your mortgage timetable.
Instead of waiting until the end of the mortgage term to repay the capital owed, many people choose to make overpayments each month. Since the monthly repayments cover only the interest, any overpayment is deducted from the capital owed. This means that it is possible to pay off, or at the very least reduce the capital owed before the mortgage term ends. It is important that you have a back up plan in place in case you are not able to pay off as much as you initially hoped by using overpayments.
Sale of a Second Property
If you own an additional property, you may wish to sell it in order to pay off the remaining capital at the end of your mortgage terms. Of course, this depends on your second property being worth enough to cover the capital borrowed with the mortgage. This is especially true if that property also has an outstanding mortgage on it, as you will need to pay off both mortgages with the money from the sale. It is not wise to depend on the sale of property to repay the capital on an interest only mortgage, as there is no guarantee of house prices being favorable when you come to sell the property.
Sell Property and Downsize
If you do not have a second property which can be sold, then it may be your intent to simply sell your home and downsize once you reach the end of the mortgage terms, leaving you with enough to pay off the capital borrowed. However, this method again depends on a favourable housing market. As an example, if you took out a 50% interest only mortgage on a property worth £200,000, you will need to pay back the £100,000 capital that was borrowed. This means that you will be depending on the property still being worth £200,000 otherwise you may not have enough leftover to purchase a new home. This is a risky repayment strategy.
Additional Interest Only Mortgage Tips
Temporary Interest Only
It is possible to use an interest only mortgage on a temporary basis. This could involve taking out an interest only mortgage to begin with, and then switching to a repayment mortgage after a few years, although this will result in an increase in repayments. A far more common situation in which temporary interest only mortgages are used is when the borrower is in financial difficulty and struggling to meet their repayments. The lender may agree to a temporary switch to interest only payments as a preferable alternative to default. This can be considered a sort of payment holiday to allow you to get your finances back on track.
Interest Only Lenders Criteria
Interest only mortgages present much greater risks to the lender and as a result most lenders offering this type of mortgage have some fairly strict criteria. Some lenders are requiring a fairly substantial deposit, often up to 50% while others will only offer an interest only mortgage to individuals who meet a minimum income criteria. It is also essential for you to show your lender how you intend to pay off the capital at the end of the loan term and for this reason some lenders are only selling interest only mortgages with a savings or investment plan attached.
Interest Only Vs. Repayment Mortgages
Whether or not an interest only mortgage is suitable will depend largely on your individual circumstance. There are both good and bad points to consider before deciding on this type of mortgage. I have outlined below some of the main advantages and disadvantages of interest only mortgages when compared with a traditional repayment mortgage.
One of the main attractions of interest only mortgages is that the monthly repayments are much lower than with traditional repayment mortgages. Only the interest is repaid, giving you the time to save enough to cover the total capital borrowed through other methods. Since the repayments are lower, it is less likely that you will find yourself in arrears. Another benefit of choosing this type of mortgage is that your overall debt will actually depreciate over time thanks to inflation. Interest only mortgages also offer a greater degree of flexibility, with lower repayments in place, if you have extra money some months it is possible to over pay and reduce the capital. Those who are buying to let can also enjoy certain tax incentives when using an interest only mortgage.
When comparing interest only mortgages to a traditional repayment mortgages, there are a number of disadvantages. One of the main disadvantages which often turns people off of interest only mortgages is that they will often require a larger deposit at the outset. That is if you can find a lender to offer the mortgage in the first place as many providers do not want to offer these mortgages mainly due to the fact that if the value of the house drops, which has been common in recent years, the lender will be locked in negative equity which will in turn pose a potential risk for the lender. The amount of interest that is paid back is much greater than with a traditional mortgage, this is because interest is paid on the full amount of the mortgage for the full term of the loan. Finally, there is no guarantee that the method you choose to fund your capital repayment will grow at a quick enough rate to allow repayment at the end of the loan term.
An interest only mortgage is not right for everybody. They tend to be most beneficial to those with an irregular income made up of commission and bonuses, and of course they rely on the borrowers ability to save appropriately so that they can cover the repayment at the end of the mortgage term. It is important to see independant advice from a mortgage advisor before committing to this type of mortgage. I can offer mortgage advice form the whole market with no broker fee. I am available most days between 11am and 9pm, so why not get in touch today