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Interest Only Mortgages: How Do They Work?

When exploring your mortgage options, one term you might come across is "interest-only mortgages." This type of mortgage can seem appealing due to its lower monthly payments, but it's essential to understand both its benefits and drawbacks before deciding. In this blog post, we'll break down the pros and cons of interest-only mortgages to help you determine if it's the right choice for your financial situation.


What is an Interest-Only Mortgage?

An interest-only mortgage means your monthly payments cover just the interest on the loan, not the principal amount borrowed. As a result, your payments will be lower compared to a repayment mortgage. However, at the end of the term, you'll still owe the original loan amount, typically requiring a lump-sum payment.


Therefore, it's crucial to have a clear plan from the beginning on how you intend to settle the total loan cost when the term ends.


The Difference Between Interest-Only and Repayment Mortgages

There are two main ways to repay your mortgage:


  1. Repayment

  1. Interest-Only


With a repayment mortgage, also known as a Capital & Repayment mortgage, your monthly payment includes both part of the loan principal (the Capital) and the interest. If you make all your payments, the entire loan will be paid off by the end of the term.


On the other hand, an interest-only mortgage means you only pay the interest each month. As a result, the original loan amount will still be outstanding at the end of the term. The main benefit of an interest-only mortgage is the lower monthly payments.

For example, if you borrow £250,000 on an interest-only basis over 30 years and at an interest rate of 5.25%, your monthly payment would be £1093. However, with a repayment mortgage for the same amount and term, your monthly payment would be £1380. This makes the interest-only option more affordable in the short term.


An interest-only mortgage can indeed reduce your monthly financial burden. However, after 30 years, you would still owe the lender the original £250,000. In contrast, with a repayment mortgage, you would owe nothing at the end of the term and own your home outright.

 

Pros of Interest-Only Mortgages

Lower Monthly Payments

One of the primary attractions of an interest-only mortgage is the lower monthly payments. This can be particularly beneficial for:


  • Buy-to-let investors aiming to maximize rental income while managing mortgage expenses.

  • Home movers seeking financial flexibility when purchasing a new home, perhaps to increase disposable income to put towards some home improvements.

  • Homeowners nearing retirement, having substantial equity in their home, and preferring not to repay more of the capital due to plans to downsize and use sale proceeds to settle the mortgage.


Investment Opportunities

Interest-only mortgages can provide additional cash flow, allowing you to invest in other areas. For instance, you could allocate funds towards:


  • Investments: By investing the money saved on lower mortgage payments, you might achieve higher returns, potentially enabling you to pay off your mortgage sooner.

  • Business Expansion: Self-employed individuals or business owners might use the extra cash flow to invest in their business, as seen in our case study below.


Cons of Interest-Only Mortgages

Repaying the original amount borrowed

One significant drawback of interest-only mortgages is the large payment at the end of the interest-only term. You'll still owe the original loan amount, which means you'll need to find a way to repay it. This could involve:


  • Selling the Property: You might need to sell your home to repay the loan, which can be stressful and uncertain.

  • Using your Savings, Pension or Investments: This requires having substantial savings, a sizeable pension pot that you can draw on or investments available when the loan term ends.

  • Refinancing: You may need to refinance the mortgage, potentially at higher interest rates.

 

Limited Availability

Interest-only mortgages are usually limited to 50%-60% of the property’s value, compared to repayment mortgages that can be available up to 95%. This can restrict your borrowing capacity and may not be suitable for those needing higher loan amounts.


Real-Life Case Studies

Case Study 1: Late 50s Homeowner

One of our clients, in their late 50s, was nearing the end of a fixed-rate mortgage that had always been interest-only. With just ten years of working life left, they were confronted with significant repayment costs due to rising interest rates. We evaluated both a full interest-only option and a part repayment/part interest-only option. Ultimately, the client opted for 50% on interest only and 50% repayment. This strategy ensures that in ten years, our client will have built 50% more equity in their home, providing greater flexibility to downsize to a suitable home to enjoy their retirement, mortgage free!



Case Study 2: Self-Employed Business Owner With Expansion Plans

Another client, who had been self-employed for two years, found their business thriving but still in its early stages. To focus on growth, they needed to reduce their monthly mortgage payments. An interest-only mortgage offered the ideal solution, enabling them to manage cash flow effectively and plan for substantial overpayments as their business expanded. This approach provided the financial flexibility necessary to invest in their business while maintaining control over their mortgage.


Conclusion

Interest-only mortgages offer attractive benefits, such as lower monthly payments and increased cash flow for investments. However, they also come with significant risks, including the need for a large lump-sum payment at the end of the term and limited availability.


Whether you're a first-time buyer, a home mover, a remortgage customer, or a buy-to-let investor, it's crucial to weigh these pros and cons carefully. If you're considering an interest-only mortgage, speak with a mortgage advisor to explore how it fits into your overall financial plan.


Ready to learn more about how an interest-only mortgage could work for you? Contact us today to get personalised advice and explore your options.


Looking for more hints and tips? Search in our Learning Centre now.

 

Your property may be repossessed if you do not keep up repayments on your mortgage


Not all Buy to Let Mortgages are regulated by the Financial Conduct Authority


Published by Beechwood Mortgages Ref: 219335 with review and approval from Stonebridge Mortgage Solutions Limited who is authorised and regulated by the Financial Conduct Authority Ref: 454811.

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