What are interest only mortgages?
Interest-only mortgages are different from full repayment mortgages because you are not required to make monthly payments towards paying off your overall debt. Instead, you simply pay off the interest on your loan.
This means that monthly repayments are often half or less than they would be with a more traditional type of mortgage deal.
On an interest-only mortgage, you are not paying off any of your overall debt, only the cost of taking out the loan that is charged by the lender. This means that at the end of your mortgage term, you still have the total amount of debt left to pay off. Normally this is done through what is known as a "repayment vehicle", which is typically an investment scheme such as an ISA or another form of saving. If you can't afford to pay off the outstanding debt, you will have to sell your home to pay it back.
Costs of interest only mortgages
Interest-only mortgages cost less per month than full repayment mortgages because you only need to pay back the interest on the loan each month. However, interest-only mortgages end up being more expensive over the lifetime of your mortgage because, even though monthly payments are lower, the amount of interest you pay each month will be higher.
This means that the attractiveness of lower monthly repayments is often outweighed by the greater financial strain this type of mortgage will place on you in the long run. Generally speaking, if you want to lower the cost of buying a house, you are better off choosing a standard repayment mortgage rather than an interest-only mortgage.
Can I get an interest only mortgage?
Because interest-only mortgages can represent a much greater financial burden in the long run, there are stricter regulations on lenders who offer them. This is to avoid consumers being landed with debt that they cannot handle and being caught out by what looks like a good offer on the surface.
The Financial Conduct Authority (FCA) has put strict laws in place to ensure that lenders make sure the person taking out a loan can afford to repay the debt in full at the end of the term. The mortgage provider must also ensure that they have assessed the income and spending of an individual to ensure they can manage payments should interest rates rise.
Buy-to-let mortgages
When somebody takes out a buy-to-let mortgage, it is almost always an interest-only loan. These types of loans are considered business loans, not mortgages, and are therefore not subject to the FCA regulations that apply to mortgages. These types of mortgages are assessed by examining the amount of rent that the mortgage holder could stand to charge, that could then be used to pay off the loan in the long run.
What else are interest-only mortgages used for?
People often take out interest-only mortgages in areas where rent is particularly high. This is because the interest on the mortgage can often be cheaper. This allows people to get a foot on the property ladder, however, it is advisable to switch to a repayment mortgage as soon as possible to avoid being stuck with a huge debt at the end of the mortgage term.
Some people also decide to gamble on house prices rising higher than the value of the mortgage during the term. If this happens you can sell the property, pay off the debt and even take home a little bit of profit. However, if your gamble fails and house prices fall, you will still need to pay off the amount of debt you borrowed initially. For this reason, it can be a very risky strategy.