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How Does an Interest-Only Mortgage Work?

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When you choose to take out an interest-only mortgage, your monthly payments only cover the interest charged by your lender on the loan amount you originally borrowed to buy your home. None of the money goes towards reducing the amount of the loan.

That’s right, the amount you owe stays the same, and you are only ever paying off the interest. That means you need to have a plan in place to pay off the full amount you borrowed at the end of the mortgage.

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What is the disadvantage of an interest-only mortgage?

Let’s compare an interest-only mortgage and a capital repayment mortgage side by side. With an interest-only mortgage, you only pay the interest on the loan.

This means your monthly payments will be much lower than with a capital repayment mortgage. However, as the amount you borrowed never goes down, you’ll end up paying more interest overall.

With a repayment mortgage, your monthly payments will include both the interest and the loan. This means the payments will be higher than with an interest-only mortgage. But over time, the amount you owe will go down, and you’ll eventually owe nothing at the end of the mortgage term.

To give an example, let’s assume no arrangement fees and no change in interest rates. For a mortgage debt of £200,000 with an interest rate of 5.75% for a 25-year term:

The interest-only mortgage will have a monthly payment of £958. The capital repayment mortgage will have a monthly payment of £1,258.

Over the full term of the interest-only mortgage, you’ll pay back a total of £487,310 (debt of £200,000 plus total interest of £287,310). With the capital repayment mortgage, you’ll pay a total of £377,325 (debt of £200,000 plus total interest of £177,325).

Why Choose an Interest-Only Mortgage?

Here are some reasons why you might consider an interest-only mortgage:

  1. Lower Monthly Payments: An interest-only mortgage can be an attractive option if you’re looking to free up some cash for renovations or expect an increase in financial obligations. The monthly payments will be lower than those of a repayment mortgage, as you’re only paying the interest charges on the amount you borrowed.
  2. Investment Opportunities: Many borrowers choose this type of loan as it allows them to use the money they would have used for principal payments to generate a higher return than the interest rate of the mortgage.
  3. Short-Term Solution: If you are planning to pay off your loan with an inheritance or bonus, an interest-only mortgage can help you keep your monthly payments low in the meantime. Alternatively, if you are planning to sell your property soon, this type of loan can also be beneficial.
  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.
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When you choose to take out an interest-only mortgage, your monthly payments only cover the interest charged by your lender on the loan amount you originally borrowed to buy your home.

Pros and Cons of Interest-Only Mortgages

pros

  • If you’re having difficulty making your monthly mortgage payments, switching to an interest-only mortgage could provide some financial relief.
  • Landlords can also benefit from an interest-only mortgage, enabling them to put aside profits to pay back the full capital. If you’ve identified an investment opportunity that requires additional capital, moving to an interest-only mortgage could free up cash for your investment.
  • If you’re thinking of selling your property in a few years, switching to an interest-only mortgage could help you manage your finances more effectively over this period. It may also be a good option if you want to free up some cash to do renovations quickly so that you can sell the flat faster.
  • If financial flexibility is important to you and you want the option to make larger principal payments when it suits you, an interest-only mortgage might be the right choice.

Cons

  • An interest-only loan means you’re not reducing your principal balance during the interest-only period. This means you owe the original amount borrowed at the end of the term and may have to make a large lump sum payment.
  • If your property value decreases, you could owe more than your property is worth when it comes to selling or refinancing. You may also pay more in interest over the loan’s lifetime compared to a traditional mortgage since you are delaying principal repayment.
  • Your monthly payments can rise significantly when the interest-only period ends, which could catch some borrowers off guard. It’s important to be prepared for this transition.
  • Using an interest-only mortgage to invest can be risky since investments are subject to market fluctuations and there are no guarantees of returns.
  • Not all lenders offer these mortgages, and eligibility requirements may be stricter than for a repayment mortgage. You may need a good credit history and a larger down payment.

How to Repay an Interest-Only Mortgage?

Choosing an interest-only mortgage depends on your financial situation and circumstances, and you need to have a strategy in place to repay the principal. Here are some ways you can do that:

  1. SELL THE PROPERTY: Consider selling your home to repay the balance. Make sure you do so in time so that the principal payment is paid on time. If you need to sell your property quickly, contact us now for a free, no-obligation cash offer.
  2. CHANGE TO REPAYMENT MORTGAGE: If you don’t want to sell your house, look into other options. You can change some or all of your interest-only mortgage to a repayment mortgage.
  3. OVERPAYMENTS: Making overpayments can help reduce the balance and lower the amount of interest you’re charged. You can stop and start them and adjust the amount whenever you like. However, be sure to check your mortgage terms to see how much you can overpay each year without being penalised.
  4. LIQUIDATE ASSETS: Consider selling investments, pensions, endowments, savings, ISAs, shares, and other properties you own to help pay off some or all of your mortgage balance. Talk to an independent financial advisor to make sure liquidating assets is the right course of action for you.

Is an Interest-Only Mortgage Right for Me?

Weigh the pros against the cons and consult a financial advisor as well as your lender prior to making any decisions.

It is essential to have a plan in place for the repayment and that you comprehend the perks and potential drawbacks of an interest-only mortgage.

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