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Understanding Interest-Only Mortgages
In the usual course of getting a mortgage, you borrow money to buy a house, and each month you pay a bit of the loan and the interest on that loan. It’s like chipping away at the whole cost, a bit at a time.
Interest-only mortgages are a bit different. They give you a choice: For a set period, you only pay the interest on your mortgage. That means you’re not making a dent in the actual mortgage amount during this time.
But, when that set period is up, you’re liable for paying back the full loan. That’s when the big payments come in.
In short, an interest-only mortgage can give you a financial breather in the short term – but should you get one?
What is an interest-only mortgage?
One can think of an interest-only mortgage as a “pay interest now, pay letter” deal. At the start of a mortgage, you get a break for a few years. During this time, you only have to cover the interest, which is the cost of borrowing money.
Once this period ends, you start paying for both the interest and the loan (principal) amount. The interest rate may change along the way, which could make your monthly payments higher.
How do interest-only mortgages work?
Interest-only mortgages often come with something called an adjustable interest rate (ARM), which means the interest rate can change from time to time. So, it’s not fixed like a regular fixed-rate mortgage.
For instance, let’s say you have a 10/20 interest-only ARM. This means you have a 30-year mortgage in total. The first 10 years are paying interest, and the following 20 years involve payments towards both the interest and the principal amount.
Interest-Only Mortgages vs Repayment Mortgages: Which is Better?
There are two ways you can repay your mortgage: interest only and repayment.
The main difference between the two is monthly payments; interest-only loans have the main advantage as you pay only the interest, making monthly repayments cheaper.
For instance, let’s say you borrow £200,000 on an interest-only basis, spread out over 25 years, with an interest rate of 3%. In this case, you’d pay around £500 a month. But if you opt for a repayment mortgage, those monthly payments would jump to £948. A pretty major difference.
The main reason why someone may pick an interest-only mortgage is because of the affordability in the short term. But, they’ll still owe the lender the same amount they started with. On the other hand, if they choose a repayment plan, they’ll own the property outright, with no debt, when the term ends.
So, it’s a bit of a trade-off. Lower monthly repayments today with the interest-only deal, but you’ll have the lump sum hanging over your head in the future. Repayment mortgages may cost you more, but they mean full ownership in the long run.
The Pros and Cons of an Interest-Only Mortgage
The benefits
- Lower starting payments: At the beginning of your mortgage, you pay less each month because you’re paying just the interest.
- Potential for faster payoff: Making extra payments towards your interest-only loan can lead to a lower principal.
- Affordable upsizing: With lower initial payments, you may be able to borrow more money, and that can afford you a bigger, cosier space.
- Extra cash: Interest-only payments can free up some money in your budget, allowing you to invest your money into other avenues.
- Possibly lower rates: Interest-only mortgages usually come as adjustable-rate loans, which might mean lower interest rates compared to fixed-rate mortgages.
The drawbacks
- No equity growth: You can’t build equity with interest-only mortgage loans until you pay off the principal.
- Risk of losing equity: If your home’s value drops, it could erase any equity you gained from your deposit, making it tough to refinance.
- Lower payments are temporary: Those low monthly payments won’t last forever. You’ll need to make higher payments when the interest-only mortgage term ends.
- Rising interest rates: Given that these mortgages often come with variable interest rates, you could end up paying more if interest rates rise.
Is an Interest-Only Mortgage Right for Me? – What to Consider Before Deciding
The ideal candidates for an interest-only mortgage are borrowers who are absolutely sure and confident they can handle the higher monthly payments that come later.
Initially, your interest-only payments are less, but they don’t chip away at your loan. This is what makes interest-only loans a bit risky.
Consider an interest-only mortgage if:
- You plan to sell your home before the interest-only period ends.
- You plan to use the home as a rental or investment property.
- You can afford the payments but want the extra cash flow for other investments and expenses.
- You’re expecting a financial boost – like retirement savings, an inheritance, or other investment – around the time the interest-only period ends.
FAQs
Do I qualify for an interest-only mortgage?
Anyone can apply for an interest-only loan, but it can be difficult to qualify as lenders will need to see evidence that you have a solid plan to repay the entire loan at the end of the mortgage term. However, your application is more likely to be accepted if:
- You can provide a large deposit or have equity in another property.
- You’re a high earner or have a large amount of savings.
How can I apply for an interest-only mortgage?
You can either approach a lender or use a mortgage broker to apply for an interest-only mortgage. Some of the best interest-only deals are often exclusively available through brokers.
A good mortgage broker, especially one who can access the entire market, will do the shopping for you and recommend the best deal that suits your personal situation.
Conclusion
Interest-only mortgages aren’t the go-to choice for everyone, but they can be handy for those who know what they’re getting into and can keep a tight grip on their finances.
At the start, you can enjoy lower mortgage payments as you only pay the interest. But once this ends, you’ll need to pay both the interest and the principal.
Sources:
https://www.lendingtree.com/home/mortgage/interest-only-mortgages/
https://www.nerdwallet.com/article/mortgages/interest-only-mortgages-what-you-need-to-know
https://www.chase.com/personal/mortgage/education/financing-a-home/what-is-interest-only-mortgage
https://www.moneysupermarket.com/mortgages/interest-only-mortgage/