What are interest only mortgages?
Interest only mortgage are mortgages where the monthly mortgage repayments include only interest payments and not capital repayments. The capital is repaid at the end of the mortgage term in one lump sum. This is contrast to a repayment mortgage where you repay both the interest and capital over the term of the mortgage in monthly repayments.
Interest only mortgages are loved by buy to let investors as they do not have to repay the capital but simply the interest and this allows them to gain more short term income and asset appreciation before disposing of the asset.
How does an interest only mortgage work?
With an interest only mortgage the lender will require you make separate agreements for paying back the capital at the end of the term(the lender will need to be satisfied with this) and the affordability assessments are different to those of a Capital repayment mortgage.
An interest only mortgage is more risky as there is a large capital requirement at the end of the term. And whilst it might seem like a much cheaper option in the short term it is actually a more expensive option as you never reduce the amount of debt you have borrowed during the term of the mortgage and so you are paying interest on a constant debt amount rather than a decreasing debt amount with a capital repayment mortgage.
Is an interest only mortgage right for you?
In the past, interest only mortgages were repaid with endowment policies but as the performances of those became worse it is now a less common method and probably will be rejected my a mortgage lender as a suitable repayment strategy.
The risk for most first-time buyers or investors with interest only mortgages is that if the property price were to fall they will find themselves with negative equity and no way to remortgage but rather stuck with a mortgage debt that is much larger than their property price.
Another big risk is the rise in interest rates which could skyrocket the monthly repayments and put first-time buyers in serious debt.
An interest only mortgage should only be taken where there is a credible plan to repay the debt and there is some plan to deal with a drastic rise in interest rates or fall in house prices.
Putting a large sum in a secure savings pot which can grow at the same or faster rate of interest which you are paying on your mortgage will go a long way to mitigate any risks down the road.
Older borrowers may also have the option to take a large sum out of their pension to pay for the interest only mortgage capital requirement at the end of the term.
In a worse case scenario the capital requirement could be paid of by selling the property. This of course only applies if the property price is higher than the outstanding debt and even at this it would have been a waste of time and money if your plan was to actually own a home.
First-time buyers seeking interest only mortgages as a short term option should be very careful as they might find themselves with no home and lost property.