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Interest-Only Mortgages


A cheaper mortgage option

When you take out a mortgage, lenders will give you two ways of paying it off: interest-only or repayment (sometimes called capital and repayment).

With a repayment mortgage, you pay back both the amount you originally borrowed and the interest you owe. But with an interest-only mortgage, you just pay interest. And because you are only paying back interest, the monthly payments are lower than on repayment mortgages.

However, if you've got an interest-only loan, once the mortgage matures, you'll still have to pay back the original amount you borrowed.

EXAMPLE: Interest-only VS Capital repayment

You take out a mortgage of £200,000 with a rate of 4.5% over 25 years

On a capital and interest repayment deal, your monthly cost will be £1,112 and at the end of the term the home will belong to you.

On an interest-only deal, your repayments will be cheaper - at £750 per month - but at the end of the term you still need to find £200,000 to pay off the loan before the home becomes yours.

How do I repay the amount borrowed?

It's best to have a plan as to how you'll do this when you take out the mortgage. You could, for example, consider monthly payments into an Isa, which - if invested sensibly - should grow by enough over the term of the mortgage to repay it.

However, there are no guarantees this will happen, whereas with a repayment mortgage, you know that as long as you keep up payments, your mortgage will be paid off at the end of the term.

However, if you've got an interest-only loan, remember that once the mortgage matures you'll still have to pay back the original amount you borrowed.

Interest only mortgages were very popular in the 1980s and 1990s and huge numbers of investment schemes were set up to pay off these loans. The most common scheme was an endowment. Endowments provided an investment which included an element of life cover so the debt would be covered in the event of death before the end of the term. They also appealed for their tax-free premiums (the tax incentives no longer apply) and a bonus on maturity.

Their shortcoming however, lay in dependence on volatile stock markets and inflation and it is thought that as many as five million endowments were sold which will not be sufficient to cover the related mortgage at the end of the term.

Interest-only mortgages

- The monthly repayments are much cheaper so buying a home is more affordable


- You are only paying back the interest each month, so you will still need to pay back the original loan amount at the end of the term

- If your repayment plan has not grown sufficiently, paying back your mortgage will be difficult

- Banks are now tightening their lending criteria for interest-only mortgages.

What else you should know

Although millions of homeowners have interest only mortgages, many do not have any repayment vehicles in place to repay the amount borrowed. Many simply rely on rising house prices so that the value of their house will eventually be high enough to repay the debt. But as the credit crunch has shown, house prices don't always rise and in fact, many borrowers could instead end up in negative equity – where the amount they owe is greater than the value of their home.

This is worrying regulators and lenders and many now are demanding borrowers show they have a repayment plan in place before they will hand over can interest-only loan.

Not only this, but many lenders are tightening their acceptance criteria. The requirements range from having an income above £50,000 to owning/having a deposit of 50% or more of the property – this would mean you'd need a deposit of £50,000 to buy a £100,000 home.

What's more, some lenders are no longer accepting savings, including Isas, as a way to repay a mortgage. For other repayment plans, such as investments or pensions, some lenders will require the value of these investments to be extremely high. For example, you might need to have a pension fund of more than £1 million and only 25% of this fund can be used to repay your mortgage.

The trend is increasingly pointing towards the ultimate disappearance of such deals as lenders' concerns grow. It may be that in the future, only a select group of lenders may continue serving what is likely to become a niche market. As a result, more borrowers will be forced to take out a repayment mortgage instead. The Financial Services Authority (FSA) also wants borrowers to only be allowed to take out an interest-only mortgage if they can afford the equivalent payments on a repayment deal. Borrowers should be able to show they are saving to pay off the loan and not simply relying on rising house prices.

So which is better, repayment or interest only?

Interest only may be cheaper in the short-term, but unless you are in a financial fix, have substantial savings or have a good repayment plan in place, the repayment route is preferable. And if you do have substantial savings, you're much better off putting them towards your deposit and opting for a repayment mortgage with a competitive interest rate. But if you do want to choose an interest-free loan, be sure to read the terms and conditions of each mortgage deal very carefully to find out whether you will definitely qualify for it.

What if I already have an interest only mortgage?

If you already have an interest only mortgage and you're concerned about the changes to these deals, you should discuss your options with your lender. If you can afford to, switch to a repayment mortgage. If the increase in monthly payments is too steep look at splitting your mortgage between a repayment and interest-only loan. Don't forget you'll still have a lump sum to pay off at the end of the mortgage. Also, be sure to find out whether you'll have to cough up any penalty fees for doing so.


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