6 min read

Interest-only mortgages

Andre Spiteri
15 May 2017

What is an interest-only mortgage? And why would you choose to go interest-only over a repayment mortgage? Here's what you need to know about interest-only mortgages.

While taking out an interest-only mortgage works out cheaper in the short-term, it’s a risky move that can have costly long-term consequences. In this article, we’ll walk you through the pros and cons of interest-only mortgages and discuss the reasons why you’d choose to take this route.

How do interest-only mortgages work?

Broadly speaking, mortgages fall into one of two main categories: repayment or interest-only.

Repayment Mortgages

Repayment mortgages are the most popular type of mortgage. The monthly repayment covers two costs: one part covers the cost of interest, while the other part gradually starts to pay off the outstanding balance on your mortgage. At the end of the mortgage term, your debt should be settled in full and you own your property free and clear.

Interest only mortgages

When you take out an interest-only mortgage your monthly repayment will only cover the cost of interest on your mortgage. This means your monthly repayment will be significantly cheaper than a repayment mortgage. However, you’ll still have to pay back the full amount of your mortgage at the end of your term.

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What are the downsides of interest-only mortgages?

Since the repayments on Interest-only mortgages only cover the interest you owe, you’ll need to figure out another way to repay the original sum.

There are several ways you can do this, ranging from putting money aside in a cash ISA or stocks and shares ISA, to dipping into your pension pot or selling the property at the end of your mortgage term. However, there’s no guarantee you’ll be able to grow your savings or investments enough to cover what you owe your lender. And there’s also no guarantee your property will fetch enough to cover the debt.

In other words, when you take out an interest-only mortgage, you’re taking a gamble. And this is inherently risky.

Some background on interest-only mortgages
During the 1980s and 90s, interest-only mortgages were sold in conjunction with endowment policies. Borrowers were promised these policies would pay off their mortgages with a nice lump sum left over when they matured, so they became very popular. Unfortunately, many of these policies fell short, which led to a nationwide scandal. Since then, interest-only mortgages have fallen out of favour; and many mortgage providers don’t offer them anymore.

Interest-only mortgages also have other disadvantages.

For one, you’ll be paying a lot more in interest over the term of the mortgage than you would on a repayment mortgage. And here’s why.

Interest is calculated as a percentage of the sum you owe your lender. In a repayment mortgage, this sum decreases as you slowly chip away at your debt. But, when you take out an interest-only mortgages, you don’t usually pay off any part of mortgage, so interest is calculated on the full sum for the entire term.

More importantly, when you add the amount of interest you’ve paid over the term of the mortgage to the original amount, chances are an interest-only mortgage will turn out to be more expensive than a repayment mortgage.

Interest-only mortgages vs repayment mortgages: the cost
Let’s say you’ve borrowed £250,000 at 3% interest over 25 years. If you take out a repayment mortgage, you’ll have to pay about £1,186 per month, or £355,800 over 25 years. By contrast, the monthly repayment on an interest-only mortgage is £625 per month. But, over 25 years, you’ll have paid £437,500 (the original £250,000 plus £187,500 in interest).

What are the advantages of an interest-only mortgage?

Despite the downsides, there are some compelling reasons why you might want to consider an interest-only mortgage. Let’s have a look.

It’s a foot in the door If you’re keen to get on the property ladder but can’t afford the higher monthly repayments on a repayment mortgage, an interest-only mortgage can be a good short-term solution

Buy-to-let properties Interest-only mortgages are popular with investors who plan to sell the property off at the end of the term. They’re also popular with professional landlords, for two reasons.

Firstly, the low monthly repayment frees up funds, which makes it easier to acquire more properties. Secondly, interest is tax-deductible. This means that, if you have an interest-only mortgage, you can deduct the full amount of your monthly repayment from your tax bill.

A change to the rules
As from the 2017/18 financial year, you’ll no longer be able to deduct all your mortgage interest from your tax bill. The amount you can deduct will be gradually reduced to 20% by 2020.

In a nutshell:
  • When you take out an interest-only mortgage, your monthly repayments only cover interest. At the end of the term, you’ll still be liable for the full amount you borrowed.

  • Interest-only mortgages are more expensive than repayment mortgages in the long term, because interest is calculated on the full amount for the duration of the term.

  • On the bright side, interest-only mortgages are a good way to get on the property ladder if you’re cash-strapped. It can also be cheaper than renting.

  • Interest-only mortgages are popular with professional landlords due to their tax benefits and because they make it easier to expand a property portfolio.

by Andre Spiteri

Andre is a former lawyer turned financial writer. Andre has written this article especially for ClearScore.

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