What is an Interest Only Mortgage?
A mortgage is a fixed term loan secured on a property. The loan is intended to be repaid in full by the end of the fixed term. Under a capital and interest, or repayment mortgage arrangement a little capital is repaid each month during the term of the loan. In this way, the full capital amount is settled before the term ends.
How an Interest Only Mortgage works
Under an interest only arrangement, the borrower services the interest only during the term of the mortgage and the full capital balance is still outstanding at the end of the mortgage term. At this point, the borrower will need to repay the capital from their own funds or by selling the property.
Borrowers use various methods to generate cash to repay the mortgage capital at the end of the term. These include investment products such as ISA’s and pensions, bonus payments, expected inheritances and sale of other property.
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The advantage to the borrower is the reduced monthly payment. The size of that reduction depends on the prevailing interest rate and mortgage term. As a rough guide, the interest only payment can be between seventy and forty per cent of the equivalent capital and interest payment.
For the client seeking an interest only mortgage, it is important to understand lenders’ attitude to these arrangements. Lenders will not allow interest only arrangements where equity or deposit is under twenty five per cent. When an interest only arrangement is requested, the lender will ask how the capital is intended to be repaid at the end of the term. Each lender has its own view of which methods of capital repayment are acceptable.
Interest only mortgages are standard arrangements for buy to let mortgages and sale of property is usually the capital repayment method. Therefore, lenders do not ask for a repayment vehicle to be in place.
The major disadvantage with an interest only mortgage is that the total amount of mortgage interest paid is likely to be higher. This is because the borrower has the full capital amount outstanding for the term of the loan.
If you would prefer an interest only arrangement, the simplest way to arrange this is via an independent mortgage broker. Your broker will understand each lender’s criteria and be able to advise you accordingly.
How to get a residential Interest Only Mortgage
In today’s market, provision of interest only mortgages for residential lending is slim. The lenders that do offer this type of lending, require that the applicant has a good level of equity (minimum 25%).
Lenders will require that the interest only applicant has a practical method of repaying the capital at the end of the term. Suitable methods include:
- PEPs and ISAs
- Pension plans
- Additional property
Of these four methods of capital repayment for an interest only mortgage, only additional property is practical for most applicants. Many lenders expect investment products such as ISA’s to already be valued at a sufficient amount to cover the mortgage capital.
Repaying capital with sale of mortgage property
Some lenders do allow borrowers to support an interest only agreement with the sale of the mortgage property as the capital repayment vehicle. In these circumstances, it should be evidenced that the borrower can downsize on repayment of the mortgage to a suitably sized home.
For this reason, lenders offering an interest only mortgage with sale of property as the repayment strategy, will set a minimum level of equity for application (typically £300,000).
This does work for many buyers, or remortgages and each case is considered on its own merits.
Split capital repayment and Interest Only
A buyer need not have the whole of their mortgage on an interest only basis, nor on a capital repayment basis. The total lending can be split between two methods. For example, one lender allows up to 50% of the lending on an interest only basis, with any extra lending (up to a maximum of 75% loan to value) on a capital repayment basis.
Issues for existing borrowers
If you currently have an interest only mortgage, be sure you have considered your method of eventual capital repayment and have plans in place.
The existing interest only borrower will have difficulty retaining interest only status when remortgaging their property, moving home, and even sometimes swapping products with their current lender.