Interest Only

What is an 'interest only' mortgage?

An interest only mortgage offers the borrower a cheaper way of purchasing a property than with a capital repayment mortgage. This is because borrowers are only paying off only the interest portion of the loan, and not the capital. For example, a £150,000 homeloan at 5% over 25 years would cost £877 per month with a capital repayment mortgage, but only £625 per month on an interest only basis.

However, at the end of the mortgage term, where the capital repayment loan will have paid off the entire debt, the interest only loan will only have paid the interest due, leaving the original £150,000 outstanding.

In order to allow for this remaining debt, interest only mortgages traditionally had some kind of repayment vehicle running alongside them, such as an endowment or pension. This allowed the borrower to with both the means to clear the debt, and a possible investment opportunity of extra funds to use as a 'nest egg'.

Interest only mortgages are commonly used by buy-to-let investors, who can claim tax back against mortgage interest, and also prove very popular with first time and next time buyers who want to keep initial costs down.

What are the risks?

Regulatory requirements used to stipulate that the lender would insist that a suitable repayment vehicle was in place, and sufficient payments were being made. These requirements have been lifted for some time, and although lenders still strongly advise that provisions are to be made, there are no checks done to confirm this.

Borrowers who take out interest only deals without repaying any capital are taking a major risk if property prices fall, as their outstanding debt will be greater than the value of their home. Even if the value of their home rises, the amount of the initial debt will not decrease.

What are the advantages?

High house prices in some areas, particularly London and the South East, mean that in some cases, an interest only mortgage can be cheaper than renting a property. Whilst the borrower may not be paying off the capital, they do own their own home and are on the property ladder. As long as they switch from an interest only to a repayment basis as soon as possible, and try to save any extra cash to help cover the costs then it can be a shrewd move. If house prices increase then you will be ahead, but if house prices fall you may ultimately face repossession. Experts warn that borrowers who never pay off their debt are simply renting from the bank or building society.