The pros and cons of interest only mortgages

At first glance, ‘interest-only mortgages’ are very appealing.

With guaranteed low monthly payments for the duration of a loan term that usually stretches to 25 years, it can feel like you’re making a long-term investment in your future.

What’s not to like?

Not so fast.

While interest-only mortgages can still be right for some people, they can also be very high-risk loans that borrowers should only enter into with their eyes wide open.

Read on -- and then check with an independent financial advisor before deciding whether an interest-only mortgage is right for you.

What are interest-only mortgages?

In general, you can pay back your mortgage in one of two ways: repayment or interest-only.

With a standard repayment mortgage, each month you repay a small amount of the original loan in addition to the interest. That allows you to slowly pay down your debt with each instalment.

But borrowers who take out an interest-only mortgage only need to make monthly payments on the interest charges on the loan, rather than payments on the original money borrowed.

As a result, monthly payments are fairly low. But borrowers still need to repay the lender the original amount of the loan, known as the capital, by the end of the term. The debt remains largely unchanged.

Interest-only mortgages aren’t as common as they were before the 2008-2009 financial crisis. That’s when financial lenders discovered that many interest-only customers didn’t have the ability to pay off their homes.

For instance, more than a quarter-million interest-only mortgage borrowers whose mortgages are due in the next 25 years have no strategy to fully repay their mortgage, according to the Financial Conduct Authority.

And the number of interest-only mortgages has been falling for years. FT Adviser has reported that they plummeted from 2.5 million in 2012 to 1.23 million in 2018 -- a 54% drop.

Still, as of 2018 nearly one-in-five mortgage-holders held an interest-free mortgage, according to the BBC.

How do interest-only mortgages differ from other mortgages?

A key difference is that monthly payments on interest-only mortgages are much cheaper than repayment mortgages.

This is because you are only required to pay the monthly interest accrued on the loan.

But interest-only mortgages usually end up costing more money than repayment mortgages in total over the lifespan of the loan.

So, for example, let’s say you take out a 25-year mortgage on £100,000 at an interest rate of 3%. For now, let’s just assume the interest rate stays the same.

• If you’d taken out an interest-only mortgage, you’d pay the provider around £250 per month.

• If you’d taken out a repayment mortgage, you’d pay the provider around £474 per month.

But it’s important to remember that under the terms of the repayment mortgage, you would own your property outright and not owe anything further on your loan at the end of those 25 years.

On the other hand, with an interest-only mortgage, you would still owe the balance on your debt. In this example, that means you’d still owe the original £100,000 that you’d borrowed.

The total amount you’d end up paying your mortgage provider would differ as well. In this example:

• If you’d taken out an interest-only mortgage, the total amount you’d pay your provider over the full term would be around £175,000 (£100,000 mortgage debt plus £75,000 total interest).

• If you’d taken out a repayment mortgage, the total amount you’d pay your provider over the full term would be around £142,200 (£100,000 mortgage debt plus £42,200 total interest).

Do I qualify for an interest-only mortgages?

Ever since the housing bubble burst more than a decade ago, it’s relatively uncommon to be approved for an interest-only mortgage.

Still, some lenders may consider you if you meet certain qualification criteria. These vary from lender to lender, but the things that tend to make you an attractive candidate include:

• A large deposit that can be put down immediately. This is likely to be between 25% and 50% the total;

• A significant and assured annual income;

• Built-up equity in another property;

• A robust, detailed plan to repay the full amount of the loan by the end of the mortgage term. This must go beyond a monthly contribution to a standard savings account or an ISA.

In short, interest-only plans are typically only available to those lucky enough to be on the high end of the wealth spectrum rather than people seeking low monthly payments because that’s all they can manage.

For these reasons as well, interest-only mortgages aren’t generally a good fit for first-time buyers.

That said, they can be right for some people.

For instance, by locking in low monthly payments, interest-only mortgages may give borrowers the flexibility to make overpayments (if permitted) in months when they know they’ll have more cash available. This can be particularly useful for people who are self-employed or otherwise have a variable income

How do I apply for an interest-only mortgage?

You can apply for an interest-only mortgage through a mortgage lender or broker, with the latter usually offering the best deals. That is because brokers can compare all available deals and then recommend the best ones for you.

According to our friends at Which?, only 18 lenders currently offer interest-only mortgages, including Post Office Money, Leeds Building Society, and HSBC. That is down from 73 lenders before the 2008 crash.

Regardless, if your financial institution does offer them, you’ll need to fulfil their qualification criteria, so check their instructions before you get started.

And although interest-only mortgages are no longer common for residential purchases, they can frequently be found on buy-to-let properties.

Read more about buy-to-let properties.

Additionally, some lenders offer retirement interest-only mortgages, which are sometimes referred to as RIO mortgages, for people in or near retirement.

As with interest-only mortgages, RIO mortgages allow borrowers to just pay the interest on the loan each month. The mortgage is then fully paid off when the home is sold when the borrower either dies or enters long-term care.

Finally, if you already have an interest-only mortgage and want to switch to a repayment mortgage, you may be able to do that. You should check with your lender directly for more information.

By now, it’s probably clear why interest-free loans have fallen out of favour since the go-go early 2000s, when a red-hot housing market created an unsustainable bubble that nearly brought down the economy.

That doesn’t mean that an interest-only loan isn’t right for you. But just be sure to do your homework and check with an independent financial advisor before signing those papers.