If you’re looking for a new home or a buy-to-let property, you’ll probably need a mortgage. One type of mortgage to consider is an interest-only mortgage. Here’s how an interest-only mortgage works, and why it’s different to a repayment mortgage.
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What is an interest-only mortgage?
With an interest-only mortgage, you’re only paying the loan interest each month. You don’t repay what you borrowed until the mortgage term ends (e.g. in 25 years).
What makes this different from a repayment mortgage? Well, the clue’s in the name. If you get a repayment mortgage, you repay the loan plus interest each month. So, you’ll pay more each month, but once the loan ends, you’ll own the property unless you’ve defaulted on any payments along the way.
How does an interest-only mortgage work?
Essentially, the amount you owe stays the same throughout the mortgage term. Think of it this way: you’re paying the interest, so the amount you owe doesn’t increase, but it doesn’t go down, either.
- If you take out an interest-only mortgage for £150,000 over 20 years, you’ll still owe £150,000 once the term’s up. You won’t own the property unless you pay this money.
- If you go for a repayment mortgage, you won’t owe anything. In 20 years, the home will be yours.
It’s simple to figure out your monthly payments. Just look at the interest you’re paying on the total sum. For example, if you borrow £150,000 on a 3% mortgage, you’ll owe £4,500 in annual interest. Over 12 months, this works out at £375 per month.
Over time, interest-only mortgages can be more expensive than repayment mortgages, but they can be more convenient because the actual monthly payments are lower. Just remember how an interest-only mortgage works, though – you’ll still need to pay the lump sum at the end!
What happens when the loan term ends?
At the end of an interest-only mortgage term, there are three main ways you can pay off the loan:
- Sell the property. However, there’s always the risk that your home will decrease in value over time, which means you’ll need extra capital to cover the shortfall.
- Remortgage the property and turn it into a repayment mortgage. You’ll still need to meet your lender’s criteria for offering a new mortgage, though, so there’s no guarantee you can do this.
- Use savings, ISAs or investments to cover the balance. Again, there’s no guarantee you’ll have sufficient funds by the time the loan balance falls due to cover the payment.
It might be worth speaking to a financial adviser for more advice on your options for paying off the home loan.
Who can get an interest-only mortgage?
There’s nothing stopping you from applying for an interest-only mortgage. If you meet the lender’s specific criteria, you could be approved. However, generally, you’re more likely to get such a mortgage if you:
- already have a large deposit;
- have plenty of equity in another property; or
- earn a high salary.
Essentially, it’s all about proving you can afford to repay the loan once the term ends. The more capital you have, the less ‘risky’ lenders think you are. So, if you’re a first-time buyer, you’ll probably find it harder to get an interest-only mortgage unless you’ve got substantial capital elsewhere.
So, we’ve covered how an interest-only mortgage works, but is it right for you? Well, it depends. Although your monthly repayments will be cheaper, you’ll still need to repay the loan at the end of the term.
Some people prefer paying more each month knowing that they own the home once the mortgage term ends. it all comes down to your personal circumstances.
Want to apply for an interest-only mortgage? Approach a lender directly or use a mortgage broker. Remember you’ll need to show you can afford the monthly repayments, so get some bank statements or proof of income ready. It might be worth checking your credit report and credit score before you apply, too.
Unsure whether an interest-only mortgage is right for you? Consider speaking to an FCA-registered financial adviser before you apply.
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