What are Interest Only Mortgages? A Complete Guide for Understanding and Applying

An interest-only mortgage is a type of home loan that allows borrowers to pay only the interest on the loan for a specified period of time, typically 5-10 years. This means that the borrower does not have to pay off any of the principal loan amounts during this time. After the interest-only period ends, the borrower is then required to start paying off the principal as well as the interest.

The main difference between an interest-only mortgage and a traditional mortgage is that with a traditional mortgage, the borrower is required to pay off a portion of the principal loan amount each month in addition to the interest. This means that a traditional mortgage will have a higher monthly payment but will also help to pay off the loan faster.

One of the main pros of an interest-only mortgage is that it can have lower monthly mortgage repayments, which can make it more affordable for some borrowers. It also allows borrowers to put more of their money towards other investments or savings. However, one of the cons is that the borrower will not be building equityThe difference between the value of the property and the amo... in their home during the interest-only period and will still be responsible for paying off the entire loan amount in full after the interest-only period ends. Additionally, if the interest rates rise, the monthly repayments will also increase.

It’s important to note that Interest-only mortgages were popular in the past, but nowadays, due to the risk of negative amortization, where the loan balance increases rather than decreases, most of the countries have strict regulations on them, and they are not widely available. Therefore, borrowers should consider their long-term financial goals and carefully weigh the pros and cons before deciding on an interest-only mortgage.

There are several types of borrowers who may benefit from an interest-only mortgage. These include:

• Investors:

An interest-only mortgage can be a good option for investors who plan to purchase a property with the intention of renting it out. With an interest-only mortgage, the investor can keep their monthly mortgage payments low, which can help to maximize cash flow from the rental property.

• Individuals with incomes:

High-income borrowers who are looking to purchase a more expensive property may benefit from an such mortgage. This type of mortgage can help to keep their monthly mortgage payments lower, which can free up more money for other expenses or investments.

• Borrowers with short-term financial goals:

Borrowers who have short-term financial goals, such as saving for a down payment on a second property or starting a business, may benefit from these mortgages. This type of mortgage can help to keep their monthly mortgage payments low, which can allow them to save more money towards their goals.

An interest-only mortgage can also help borrowers with specific financial goals. For example, it can help to free up more cash flow for investments or savings. Additionally, it can help borrowers to qualify for a larger loan amount by keeping their monthly mortgage payments lower.

It’s important to note that Interest-only mortgages are not widely available, and borrowers should consult with a mortgage broker to know if they qualify and if it’s beneficial for them.

Read about Lifetime Mortgage vs Retirement Interest-Only Mortgage in our other blog/

What are the two different ways to pay mortgage payments and how do they differ – interest only or repayment?”

There are currently two different ways to pay your mortgage payments – interest onlyA mortgage where the borrower only pays the interest on the ... or repayment.

As the term implies, you are only paying the interest part of a mortgage loan and you don’t have to repay the amount you’ve borrowed until the end of your mortgage term, unlike repayment mortgages where the loan will be cleared at the end of the term.

Read on to find out if an interest-only mortgage option is right for you.

What are interest only mortgages and how do they work?

As you are only paying the interest part of your mortgage throughout the term with an interest only mortgage, the capital you borrowed remains outstanding at the end of the term unless you have another way to clear the debt in full.

A ‘repayment vehicle(s)’ is required to pay off the total amount borrowed at the end of your mortgage term.

Interest only mortgages might be attractive to buyers who wish increase their cash flow or to invest the money elsewhere or perhaps buy-to-let landlords who wish to save the rental income to pay off the capital loan. First-time buyers may choose this option to ease their outgoings till their income eventually rises as they gain more experience in the workforce a few years down the line (although the lender’s offering is a niche for first-time buyers).

Interest only lending has decreased since the financial crisis in 2008 as prior to this, customers were not required to show lenders how the debt would be repaid and they found after the credit crunch, a proportion of interest only customers struggled to find a way to repay the capital they borrowed. There are now increasing numbers of lenders willing to bring back interest-only lending but with much stricter lending criteria and requirements.

Ways of repaying an interest-only mortgage:

You must be able to show lenders how you can repay the outstanding mortgage at the end of the term and can’t rely on the promise of windfalls such as a bonusIncome received as a bonus, which may affect a borrower's ab... or an inheritance.

Mortgage Lenders will assess whether a client’s chosen repayment vehicle is likely to pay off the capital borrowed at the end of the mortgage term and make a decision on whether to lend. They will also check at least once during your mortgage term to ensure your repayment plan is performing as expected to enable you to repay the loan at the end of the interest-only mortgage term.

Examples of repayment vehicles:

– Pensions
– Cash saved in an ISA or savings account
– Endowment policies (regular savings plans)
– Stocks and shares ISAs
– Investment funds
– Other properties or assets
– Selling the property to pay back what you owe to the lender

A suggestion could be for someone who wishes to use an interest only mortgage is to make overpayments each year (usually 10% of the outstanding loan amount is free from early repayment charges). This means if your cash flow or interest rates goes up or down, you can adjust your overpayment amount to suit your needs and it will decrease your risk.

Pros:

• Lower monthly payments as you are only paying the interest of the loan.
• Increases cash flow to invest and grow wealth.
• More flexibility to choose where your money goes.
• Can use the extra money to make home improvements which could raise the property value.

Cons:

• Interest only could cost more in interest over the term, as you are charged interest on the whole amount borrowed, whereas, with repayment mortgages, the capital decreases over the term, which means interest paid should also decrease.
• Not as many lenders offer interest-only products due to the risks involved.
• A plan needs to be set in place to repay the capital at the end of the term as there is no guarantee selling the property could pay it off as the property market could become unpredictable and the same applies to investments where funds may be less than you were expecting.
• Time-consuming as you have to keep track of your mortgage and investments.
• More risky and complicated.

How to Get an Interest-Only Mortgage

Getting approved for an interest-only mortgage can be a bit more challenging than getting approved for a traditional mortgage. The qualifications and requirements for getting approved for an interest-only mortgage can vary depending on the lender and the specific loan program, but some common qualifications and requirements include:

• Good credit score: Borrowers should have a good credit score in order to be approved for an interest-only mortgage. A credit score of at least 620 is typically required, although some lenders may require a higher score. However, If you have a bad credit score, you still can apply for such mortgages, but you may need to contact a specialist mortgage provider for suitable options.
• Strong income and employment historyA record of a borrower's employment history, which may be us...: Borrowers should have a strong income and employment history. Lenders will typically want to see that the borrower has a stable income and a good employment history.
• Enough cash reserves: Borrowers should have enough cash reserves to cover the mortgage payments for the interest-only period. Some lenders may require borrowers to have a certain amount of cash reserves on hand in order to be approved for an interest-only mortgage.
• Adequate property value: Borrowers should have a property that has adequate value to secure the loan.

What are the steps involved in getting such mortgages?

The steps involved in getting an interest-only mortgage include the following:

1. Research lenders and loan programs to find the best option for you.

2. Gathering the necessary documents, such as proof of income, credit score, and other financial information.

3. Applying for the loan with the lender of your choice.

4. Meet with a loan officer to discuss your options and review the loan documents.

5. Signing the loan documents and closing on the loan.

6. Make regular payments on your interest-only mortgage until you reach the end of the term. At that point, you will need to either refinance or pay off the remaining balance in full.

It is important to remember that interest-only mortgages can be risky and complicated, so it is important to do your research and make sure you understand the terms of the loan before signing any documents. Additionally, it is important to have a plan in place for how you will pay off the remaining balance at the end of the term.

Next steps

There are many factors to consider when deciding whether to use an interest only mortgage and it will depend on your personal and financial situation and your attitude to risk. If you wish to seek further advice to be able to decide whether an interest only mortgage is suitable for you, please do not hesitate to contact us. We are a team of market mortgage brokers who can help you with a suitable mortgage deal.

Frequently Asked Questions

How does an interest-only mortgage differ from a traditional mortgage?

An interest-only mortgage differs from a traditional mortgage in that the borrower only pays the interest on the loan for a predetermined period of time. At the end of this period, the borrower must either refinance or pay off the remaining balance in full. With a traditional mortgage, borrowers make regular payments towards both principal and interest throughout the life of the loan. Additionally, with an interest-only mortgage, the monthly payments are typically lower than with a traditional mortgage.

Who is eligible for an interest-only mortgage?

In order to be eligible for an interest-only mortgage, borrowers must meet certain criteria. Generally, lenders will require that borrowers have a strong income and employment history, enough cash reserves to cover the payments during the interest-only period, and adequate property value to secure the loan. Additionally, some lenders may also require a higher credit score or down payment in order to qualify for an interest-only mortgage. It is better to contact a mortgage provider to help you with a suitable plan and repayment strategy for such mortgages.

What are the benefits and drawbacks of an interest-only mortgage?

As discussed above, one of the main benefits of an interest-only mortgage is that the monthly payments are typically lower than with a traditional mortgage. Additionally, borrowers may be able to use the extra cash flow to pay off other debts or invest in other areas. However, there are also some drawbacks to consider. Since borrowers are only paying interest during the term, they will not be building equity in their homes and will need to pay off the remaining balance in full at the end of the term. Additionally, interest-only mortgages can be risky and complicated, so it is important to do your research and make sure you understand the terms of the loan before signing any documents.

How can I increase my chances of getting approved for an interest-only mortgage?

In order to increase your chances of getting approved for an interest-only mortgage, it is important to make sure you meet the criteria set by lenders. This includes having a strong income and employment history, enough cash reserves to cover the payments during the interest-only period, and adequate property value to secure the loan. Additionally, some lenders may also require a higher credit score or down payment in order to qualify for an interest-only mortgage. It is also important to shop around and compare different lenders in order to find the best deal.

What is a repayment mortgage and how are these different from interest only mortgages?

A repayment mortgage is a type of loan where the borrower pays both interest and principal each month. This means that the loan balance decreases over time, and the borrower will eventually pay off the entire loan. With an interest-only mortgage, however, the borrower only pays the interest on the loan for a predetermined period of time. At the end of this period, the borrower must either refinance or pay off the remaining balance in full. Repayment mortgages are generally considered to be less risky than interest-only mortgages, as they allow borrowers to build equity in their homes and pay off the loan over time.