Guide to Interest-Only Mortgages: Is It Right For You?

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 onlyA mortgage where the borrower only pays the interest on the ... 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.

If you are looking for interest-only mortgages with low monthly payments, you are on the right page. This guide contains all the articles related to interest-only mortgages.

What are interest-only mortgages, and how do they work?

Interest-only mortgages are a type of mortgage in which the borrower is only required to pay the interest on the loan each month rather than pay off any of the principal amount borrowed. This means that the monthly payments are typically lower than with a traditional mortgage.

Interest-only mortgages might be attractive to buyers who wish to increase their cash flow or 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 until their income eventually rises as they gain more workforce experience a few years later (although the lender’s offering is a niche for first-time buyers).

Ways of repaying an interest-only mortgage:

An interest only mortgage allows borrowers to pay only the interest on the loan during a specified period, typically at the beginning of the loan term. Unlike a traditional repayment mortgage, where both interest and principal are paid each month, with an interest-only mortgage, the borrower’s monthly payment covers only the interest charges on the loan, not any of the original capital borrowed. Here’s how it works and some considerations for repayment:

1. Monthly Payments: With an interest only loan, your monthly payments are significantly lower than those of a repayment mortgage. For example, if you borrow £250,000 on an interest-only basis for 25 years, you’ll pay only the interest on the amount borrowed each month. When the 25 years are up, you’ll have to repay the full £250,000¹.
2. Repayment Plan: The critical aspect of an interest only loan is having a credible repayment plan in place to pay off the original loan amount (the capital) at the end of the term. Lenders require borrowers to demonstrate how they’ll repay the principal. You can’t rely on future windfalls (like bonuses or inheritances) or speculate on property price increases. Instead, consider these 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.
3. Overpayments: If you choose an interest only loan, consider making overpayments each year (usually up to 10% of the outstanding loan amount without early repayment charges). This flexibility allows you to adjust your overpayment amount based on changes in cash flow or interest rates, reducing risk.
4. Pros and Cons:
   • Pros:
     • Lower monthly payments due to paying only interest.
     • Increased cash flow for investment and wealth growth.
     • Flexibility in allocating your money.
     • Extra funds for home improvements that could raise property value.
   • Cons:
     • Interest-only loans may cost more in interest over the term because you’re charged interest on the entire borrowed amount.
     • Fewer lenders offer interest-only products due to associated risks.
     • A clear plan is essential to repay the capital at the end of the term, as selling the property or relying on investments can be unpredictable.
     • Managing your mortgage and investments can be time-consuming and complex.

Remember that interest only mortgages require careful planning and understanding of the risks involved. Evaluate whether this type of mortgage aligns with your financial goals and circumstances.

How to Get an Interest-Only Loan?

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 loan 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.

Interest-Only Mortgages: Frequently Asked Questions

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

With an interest-only mortgage, you only pay the interest on the loan for a set period. You must either refinance or pay off the remaining balance at the end of this period. In contrast, a traditional mortgage requires payments towards both principal and interest throughout the loan, gradually reducing the debt. Interest-only mortgages typically have lower monthly payments.

2. Who is eligible for an interest-only mortgage?

To qualify for an interest-only mortgage, borrowers generally need:

• A strong income and employment history
• Sufficient cash reserves to cover interest payments during the interest-only period
• Adequate property value to secure the loan
• Some lenders may also require a higher credit score or larger down payment

It’s best to consult a mortgage provider to explore suitable plans and repayment strategies.

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

Benefits:

• Lower monthly payments
• Potential to use extra cash flow for other purposes, such as investments or debt repayment

Drawbacks:

• No equityThe difference between the value of the property and the amo... built during the interest-only period
• Full balance due at the end of the term
• Can be risky and complex, requiring careful consideration and research

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

To improve your chances of approval:

• Ensure you meet the lender’s criteria (strong income, cash reserves, property value)
• Maintain a good credit score
• Consider a larger down payment
• Compare different lenders to find the best deal

5. What is a repayment mortgage, and how does it differ from an interest-only mortgage?

A repayment mortgage involves paying both interest and principal each month, gradually reducing the loan balance over time. This allows borrowers to build equity in their homes and eventually own them outright. Interest-only mortgages, on the other hand, only require interest payments for a set period, leaving the entire principal balance due at the end. Repayment mortgages are generally considered less risky due to their steady debt reduction.