Guide to interest-only mortgages
- With an interest-only mortgage you only repay the interest accrued each month, not the capital
- This means you’ll have to find another way to repay the capital at the end of the mortgage term and lenders will ask for evidence of your repayment plan, such as investments or other properties to sell
- If you took an interest-only mortgage when lending rules were less stringent, you may be facing a shortfall at the end of your term - address this now by looking into remortgaging, overpaying, or extending the term
Pre-credit crunch, it was fairly common to be able to get a residential mortgage where you only had to repay the interest accrued each month.
That would mean that, at the end of the mortgage term, the amount you owed would still be the same as at the outset of the mortgage.
Of course, you were still expected to repay the capital eventually, but you’d be allowed to have an alternative strategy for doing this, rather than simply paying off a bit of capital each month.
But then in 2008, house prices plummeted and financial markets collapsed, and the realisation dawned that these strategies for repaying might not actually work.
While it’s quite hard to find an interest-only mortgage for a residential purchase (or even for a remortgage if you’re an existing interest-only mortgage holder) these days, they are still common on buy-to-let properties - read our buy-to-let mortgages guide for more on this.
What’s more, all the people with interest-only deals from the 1990s and 2000s must now face up to dealing with their debt and finding a way to repay their loans.
Interest-only mortgages are still available, but they’re no longer offered to borrowers at the lower end of the affordability scale.
Instead, criteria are likely to include a very high minimum income and a substantial deposit - usually of at least 25% and sometimes as high as 50%.
What’s more, it’s likely you’d need to show evidence of a robust repayment plan - simply putting money away in savings or Isas is unlikely to cut it in many cases.
The basic rule is that interest-only mortgages are likely to only be available to those well-off enough to afford a standard repayment mortgage - not to people looking for lower monthly payments because that’s all they can afford.
Part-and-part mortgages are a kind of hybrid between an interest-only mortgage and a repayment one. Basically, only part of your mortgage will be interest-only; the rest will function like a normal repayment mortgage.
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For instance, if you want a mortgage for £75,000 on a £100,000 house, the lender may only allow 50% of the value of the home to be lent on an interest-only basis.
However, they might allow the rest to be borrowed on a repayment basis.
So, for the £100,000 house, your payments to the lender would be interest-only on £50,000 of your loan and repayment on £25,000.
This type of mortgage might be useful for buyers who want lower initial monthly payments to make things more affordable in the early years.
However, be aware that lenders will still require evidence of a repayment vehicle for the interest-only portion of your mortgage.
How many people already have interest-only mortgages?
The percentage of interest-only mortgages decreased steadily through 2014 and 2015. According to Bank of England statistics, interest-only mortgages fell from 10.38% of all advances in the first quarter of 2014 to 7.61% in the second quarter of 2015.†
In the first quarter of 2008 this figure was 43.81%, so it’s clear that the mortgage industry has taken steps to substantially reduce interest-only borrowing since its peak.
Although new interest-only mortgage lending is far lower than in the past, there are still plenty of homeowners who took one of these products before 2008.
In 2009, existing interest-only mortgage balances peaked at an average over the year of 37.83% of total existing mortgage balances. By 2014, this average had been brought down to 28.23% - so interest-only still accounted for more than a quarter of existing mortgage debt.
Bringing interest-only mortgage numbers down
In November 2015, the Council of Mortgage Lenders (CML)† noted: “The volume of new interest-only mortgages has declined substantially from its peak in the mid-2000s. However, most lenders will have borrowers with existing interest-only mortgages for many years to come.”
It said that 2.8 million residential interest-only mortgages were outstanding in 2014.
In 2014, lenders took on a major exercise to contact some 720,000 borrowers with interest-only mortgages that mature on or before 2020 to encourage them to discuss their repayment plans.
By 10 June, 2014, 30% had responded and four out of five had a clear plan for repaying, according to the CML. Of those that did not, solutions offered might include term extensions, permanent conversions to capital and interest and overpayments.
Why choose an interest-only mortgage?
With warnings of an ‘interest-only time bomb’ bandied about by the press over the irresponsible lending of the pre-credit crunch years, you might wonder why anyone would want an interest-only mortgage - but they can be a good fit in some circumstances.
Never be tempted to try to take out a buy-to-let mortgage on your own home to secure an interest-only deal.
This is considered mortgage fraud and could result in you being asked to repay the full mortgage immediately.
It could also make it difficult to get a mortgage in future.
For example, if mortgage interest rates are low and you fit the wealthy buyer criteria described above, you might want to use the money you would have used to repay the mortgage to invest elsewhere instead.
What’s more, paying only the interest gives you some flexibility - you’re keeping your basic monthly payment as low as possible, but if overpayments are permitted you could choose to make overpayments at times when you have more money available.
This sort of flexibility can be particularly useful if you have a variable income, for instance if you’re self-employed.
Repaying an interest-only mortgage
Whether you’re an existing interest-only mortgage customer, or you want to take one out, you’ll need a strategy for repaying. As mentioned, many lenders won’t accept savings accounts and Isas as a repayment strategy any more.
Each lender will have their own criteria for what’s acceptable as a repayment vehicle, so it’s a good idea to speak to a mortgage adviser to guide you towards one that’s compatible with your own plans.
Investments such as bonds, shares and unit trusts are a popular repayment vehicle for interest-only mortgages.
Endowment policies are investments which work a bit like a regular savings plan - you pay in regularly then, after a set period of time, you receive a guaranteed minimum lump-sum payment. These policies also include life assurance, so they pay out if you die before the end of the policy term.
These were once a favourite repayment strategy for interest-only buyers in the 1990s, but many have since found out that their investments have underperformed drastically. In many cases, these homeowners have been left facing a shortfall and having to either find extra money to repay the mortgage, or sell up.
Some lenders will accept a personal pension plan as a repayment vehicle.
You make contributions each month to your personal pension scheme and upon retirement you can choose options such as a tax-free lump-sum payment and/or a taxable regular income. The lump sum may be used to repay the outstanding mortgage.
As with endowment policies, a pension plan is an investment and poor performance could mean the lump sum is insufficient to repay the mortgage.
If you have rental properties or other assets, some lenders will allow you to use their sale as a repayment strategy for your interest-only mortgage.
If your plans for repaying your interest-only mortgage result in a shortfall, you may find that you have no option other than to sell your home to repay the mortgage. Depending on how much you have left after the sale, you could consider downsizing or moving into rented accommodation.
If you chose an interest-only mortgage in the 1990s or 2000s when they were more freely available, you may now have realised that your repayment vehicle might not cover the full mortgage cost - or you may not have a repayment vehicle at all.
If that’s the case, you might want to consider remortgaging to something more appropriate.
Alternatively, if you think a repayment product would stretch your monthly finances, they can help you consider options like extending your mortgage over a longer term, such as 30 or 35 years.
You might even be able to remortgage to a more competitive interest-only or part-and-part deal.
But remember, even with a remortgage you’ll most likely have to provide evidence of a robust repayment strategy to show that you can pay off the capital at the end of the term.