Mortgage payments are probably one of the things that plague us the most. One moment they are fine, then the rates go up and affordability goes out the window. Then, rates come down, but you are stuck on a 5-year fixed term at the high rate that was the best available at the time. It’s draining. 

One potential solution many consider is the interest-only mortgage. You can change to an interest-only mortgage from a repayment mortgage, and it can be beneficial thanks to lower monthly payments, but you need a plan in place and in this blog, we explain all.

What is an interest only mortgage?

An interest-only mortgage is a form of loan where the monthly payments cover just the interest the mortgage accrues. This leaves the capital debt outstanding, and it must be cleared upon the end of the mortgage term. Payments are lower than typical repayment mortgages, but you must have a plan in place to clear the capital debt at the end of the term.

This is somewhat different to the repayment mortgage most of us have. With a repayment mortgage the monthly payments are higher, but you chip away at both the interest and the capital debt. This makes the property yours outright once the debt has been paid.

As of the end of 2023, there were fewer than 800,000 regulated whole interest only mortgages* outstanding according to the FCA. This makes up just 9% of the total regulated mortgages in the UK.

For lower monthly repayments, an interest-only mortgage can be beneficial, but you run the risk of losing your home at the end of the agreement if you can’t settle the capital debt. At the same time, high monthly payments on a repayment mortgage may push you further into debt and make the basic cost of living significantly more difficult to achieve.

Before you apply for an interest only mortgage

Before you do anything, you should carefully look at your finances to see if this is an option you feel comfortable with. Whilst you could be spending less money each month, the capital debt will still be there at the end of the mortgage term. If this is not something you feel you will be able to manage, you should remain on your current mortgage or seek remortgaging advice from a mortgage broker.

They may suggest you look to borrow from a lender that has signed up to the mortgage charter. Lenders that are part of the charter allow a six-month transition to an interest only mortgage without the need for an affordability check. This allows you to lower your outgoings for six months by only paying the interest on the mortgage. After this time, your mortgage returns to its original repayment type, however, the monthly payments on repayment will increase because you would have not reduced the balance of the mortgage over that 6 months so the paayments will be a little higher to cover the extra capital you missed. Potentially money saving without the worry of having to lose the house at the end of the term.

Interest Only mortgagwe are not generally recommended due to the fact you do not repay the capital over time as you will have to repay the balance of the mortgage at the end of the term of the mortgage. Plus there is so much more criteria you must meet on order to qualify for an Interest Only mortgage. Different lenders have different criteria so best to speak with an adviser to see if it is in fact available to you.

Applying for an interest only mortgage

Many lenders will be happy for you to switch to an interest-only mortgage. After all, if you cannot pay the capital debt at the end of the term, they will ask you to sell your property to repay their debt if you cannot afford to do so.

When applying for the switch to an interest only mortgage you’ll need to demonstrate to the lender that you pass their criteria.

Repayment of the mortgage

The lender will want to know how they are getting their money back. As your monthly payments are only paying off the interest, there is still a lump sum to pay at the end of the term of your mortgage. A lender will want to see how you plan to make this possible. Do you have savings that could be used? Do you have buy-to-let properties that generate revenue or you could sell to realise the capital to repay the mortgage? Or would you just sell the home at the end of the mortgage?

Regardless, they will want to know how they are getting their money back.

Credit score

Whilst the mortgage charter allows you to go interest-only for six months, a longer-term interest-only mortgage requires you to show your affordability. This is largely because such a mortgage is riskier for a lender than a standard repayment mortgage. With a repayment mortgage, every payment gives the bank back some of its money. With an interest-only mortgage, they may not see any payments of the loan itself for many years.

The amount of equity

The lender will want to see how much of the property is owned by you. The simple rule is, the higher the equity, the higher the likelihood of approval. Many lenders will require you to have a minimum amount of cash value in your property and not allow you to borrow more than 50% or 75% of your property value on Interest Only.

Pros and cons of an interest only mortgage

Choosing an interest-only mortgage can be full of benefits but it also has a few disadvantages too.

Advantages of an interest-only mortgage

• Significantly lower payments each month: Less money being spent on the mortgage means more money to spend doing the things you enjoy.
• Helpful in times of hardship: If money is becoming an issue, reducing your payments can help you tackle other debt or help provide more for your family. This is what the Mortgage Charter is for, to give you six months grace.
• Chances to make a profit. The saved money can be invested, potentially making you more money that can go towards paying the capital debt.

Disadvantages of an interest only mortgage

• More expensive overall. Even though each month is more affordable, the total you pay back will be much higher.
• Very risky. If you are banking on a repayment plan to rrepay the capital debt it may not be on track to do so, so close monitoring of any investments is a must to ensure your repayment vehicle is on track to have enough to repay the mortgage at the end of the term.
• Negative equity. If property prices fall, you could find that your mortgage is more than the house is worth. This could make getting a new mortgage extremely hard in the future.

Can I switch back from an interest-only mortgage?

If you have gone from a repayment mortgage to an interest-only mortgage and want to switch back, you can. The lender will have to carry out a full affordability assessment to see if they are happy to transfer you back to repayment.

Just be aware that your monthly payments will jump significantly as you move to a repayment mortgage, and this is something you will need to budget for. Especially if you have not been used to paying back such an amount each month.

Mortgages are tricky at the best of times, with confusing rates and deals at every turn. Take the stress out of mortgages by utilising us. We are the free mortgage broker who put you first. Our experienced team guides you through the mortgage minefield to help you find the best option for your needs. Whether first time buyer mortgages are on the agenda or you’ve decided it’s time to speak to equity release brokers, we can help. Our impartial advice and extensive knowledge mean that your options for interest-only or repayment mortgages will always be backed with supporting evidence, allowing you to make a fully informed decision. Contact us today to see how we can help.

Sources

*https://www.fca.org.uk/publication/research-notes/interest-only-mortgages-analysis-fca-mortgage-data.pdf