Basically… it’s a little “what it says on the tin”, but an interest-only mortgage is an agreement where you pay only the interest owed on your loan each month.
Popular in the 1980s and 90s, and peaking just before the 2008 financial crisis, interest-only mortgages benefit those who are trying to keep their monthly payments down in the short term.
How does an interest-only mortgage work?
You only pay off the interest on the amount you borrow – not the loan itself.
This differs from more common repayment mortgages which see you pay off the interest and some of the capital on your home each month, eventually leading to the mortgage being paid off at the end of the term.
With interest-only, you’ll have to pay off the total amount borrowed in full at the end of your mortgage term using savings, investments or other assets.
You can also find temporary arrangements if you are struggling financially.
Example: You’re looking at a house which requires you to borrow £100,000 over 25 years with a fixed interest rate of 3.5%.
Imagining this interest rate stays the same for the whole term, on a repayment mortgage plan your monthly cost would be £501, while on interest-only it would be significantly lower at £292.
The interest-only option is great for those who want to keep their outgoings in check – but it does mean that, as the capital isn’t being paid down, the amount of interest ends up being higher than on the full repayment plan.
Therefore someone on an interest-only deal would owe £187,579 (£87,579 interest plus £100,000 loan capital outstanding), while a repayment deal would see them pay back £150,238 (£100,000 loan capital fully paid off plus £50,238 interest).
How easy are they to come by?
As we touched on earlier, prior to the 2008 financial crisis interest-only mortgages were much easier to get hold of – some 40% of all mortgages taken out were interest-only around this time.
But the crash revealed that many loans were at risk with customers who would struggle to pay off the full loan later down the line.
Affordability criteria were introduced as a result, which caused their popularity to sharply decline. It’s now quite difficult to borrow on an interest-only basis, with not all lenders offering them as an option.
Those that do will have strict terms, such as a high deposit and an approved plan to pay the loan back at the end of the term.
Research by the Financial Conduct Authority in August last year revealed that the number of interest-only and part-interest-only mortgages had halved since 2015.
What are the benefits?
The biggie with interest-only mortgages is the reduced monthly payments, which can provide you with a financial safety net if you go through times when you’re earning less.
There’s also a chance that if you’re in your property for a long time, you could sell it for more than you paid for it, meaning you’ve built up equity to help you pay off the lump sump.
What about the downsides?
You’re not paying off any of the loan as you go, meaning you’re not building up that equity that you would do with a repayment mortgage. You’ll also end up paying more interest due to not making a dent in the capital.
Interest-only also means you need a solid plan for paying it off at the end of the term – this may include constant monitoring of investments and being strict with yourself to ensure you’re putting money aside. With a repayment plan you don’t need to think about this element.
Read other entries in our Basically series…
Source: Money blog: Smoke machines deployed in Tesco; big inflation moment forecast
