| |
Interest-only mortgage?
|
Interest-only mortgages
Compare Mortgages >>
Friday 14 Novemember 2008
By Becca Talbot
becca.talbot@consumerchoices.co.uk
What are the pros and cons of taking out an interest-only mortgage? Whether you’re a first-time buyer or looking to remortgage, you need to consider which mortgage repayment plan is best for you.
The most important thing to consider when choosing a mortgage is how you’re going to pay back the money you borrow, and the interest on that. There are currently two ways in which you can repay your mortgage: repayment or interest-only. This article looks at the option of repaying interest-only:
Sarah Robson of the Council of Mortgage Lenders advises: “Borrowers wanting to take out an interest-only mortgage need to do so with their eyes open. You need to realise you won’t be repaying any of the capital, and at the moment you can’t rely on house price inflation to provide you with an equity cushion.”
Robson also suggests that interest-only mortgages should really only be considered if you’re in a spot of financial trouble: “You will have fewer options available to you if you get into difficulty, as switching to interest-only is seen as a coping strategy for borrowers with payment problems.”
At the end of the guide we recommend the best way to ensure you get the right mortgage for you.
Interest Only Mortgages Compared >>>
What is the difference between a repayment mortgage and an interest-only mortgage?
| Repayment mortgages |
Interest-only mortgages |
| Make monthly repayments for an agreed period of time (the term) until you’ve paid back the loan and interest. This is considered the least risky mortgage type, as well as the easiest to understand. |
Make monthly repayments for an agreed period, but this will only cover the interest on your loan. You’ll have to pay into another savings or investment plan each month as well, to pay off the capital by the end of the term. |
You must remember that with an interest-only mortgage, at the end of your mortgage term (typically 25 years, however this could be longer or shorter) you will still owe the original amount you borrowed, the capital.
The idea behind this type of mortgage is that you have a separate savings or repayment vehicle running alongside it, into which you also make monthly payments, so you have the money to pay off the capital at the end of the term.
Interest-only example:
HSBC currently offer an interest-only mortgage of up to 80% of the value of the home (LTV). Using the BBC’s mortgage calculator, a £150,000 home loan at the bank’s current SVR of 6.25% over 25 years would cost £781.25 a month interest-only, and £1001.18 per month capital repayment.
However, you must remember that at the end of the mortgage term, the interest-only loan will have paid off only the interest - leaving the original £150,000 debt to be repaid, whereas the higher monthly payments of a repayment mortgage would have cleared the debt.
|
Back to the top
What is a repayment vehicle?
Most customers with an interest-only mortgage will make monthly contributions to a repayment vehicle, such as an ISA, to pay off the capital borrowed on their house.
Contributions to the repayment vehicle are invested with the aim of building a lump sum that will be enough to pay off your mortgage.
Katie Moore from Nationwide (www.nationwide.co.uk) warns that you choose and monitor your repayment vehicle carefully to avoid financial trouble: “Performance of a repayment vehicle is not guaranteed, and you will need to keep a watchful eye on it to ensure you are not left with a shortfall.”
If you can manage your finances properly, an interest-only mortgage can have a one advantage: You can choose your own repayment vehicle - one that is tax efficient and which will show good growth.
This is only an advantage if you can manage your finances properly, and anyone considering an interest-only mortgage should always seek guidance from an independent financial adviser before going ahead.
To find an independent adviser in your area, click here
Back to the top
Who is suitable for an interest-only mortgage?
As an interest-only mortgage can later be changed to a repayment mortgage, they have become increasingly popular with first-time buyers who are finding it hard initially to afford the costs of a repayment mortgage.
It is important to remember that taking out an interest-only mortgage with a view to changing to a repayment mortgage in the future may incur a penalty from you lender.
Mortgage adviser Tracy Collins, of the Guild of Independent Mortgage Advisers (GOIMA) suggests that interest-only mortgages may be suitable for students and graduates whose financial situation will improve: “If a client is part way through training or studies, such as a nurse, or a doctor, and they are presently on a low income but their financial situation will change considerably within the coming years, I may suggest an interest-only mortgage,” she says.
“I would advise interest-only as a more affordable way of getting onto the property ladder, knowing that when this client is due for a remortgage in 2 or 3 years time I can then put that client on a repayment mortgage, when they have more disposable income and maybe even reduce their term, in line with their new budget.”
Interest-only mortgages are also used by buy to let investors.
Back to the top
What do the lenders think of interest-only?
While repayment vehicles are no longer essential for an application for an interest-only mortgage, many lenders still insist on seeing evidence that one has been set up.
Abbey (www.abbey.com) for example will lend up to 50% loan-to-value (LTV) of the property in a pure interest-only mortgage, and up to 75% LTV with evidence of a repayment vehicle put in place to pay off the capital at the end of the term.
And Halifax (www.halifax.co.uk mortgage customers must provide evidence of a repayment vehicle before they can sign up to an interest-only deal. The repayment vehicle can come in a number of forms:
- Investment plan (an endowment, ISA, unit trust, frozen PEP or a combination of any)
- a pension
- cash savings
- stocks and shares
- unit trust or trust fund
- an investment bond
- the sale of a business, commercial property (eg buy-to-let house), a residential property (eg a second home or commuter home) or non-property assets
- inheritance
- employment bonus
Back to the top
Who offers interest-only mortgages?
The table below shows five of the UK’s largest mortgage providers, and the loan-to-value percentage of the property they are prepared to offer borrowers on an interest only deal. It also shows how the LTVs have changed over the last 10 months, with the current financial climate and house prices falling as they are:
|
| Mortgage provider |
Maximum LTV (Jan 2008) |
Maximum LTV now (Nov 2008) |
Extra Details |
| Halifax |
90% |
95% |
Minimum loan £100,000, must see evidence of repayment vehicle |
| Abbey |
85% |
50% |
|
| Nationwide |
66% |
66% |
|
| Northern Rock |
95% |
90% |
|
| HSBC |
80% |
80% |
Minimum salary £25,000 |
Back to the top
What are the dangers of an interest-only mortgage?
There are a number of risks with interest-only mortgages, all of which should be considered when choosing how you want to repay the money you borrow.
Firstly, house prices are never guaranteed – while overall trends suggest they will increase, recent figures have shown a 15% decrease in property prices over the last 12 months. Those taking out interest-only deals without a repayment vehicle to pay off the capital are speculating that property prices won’t fall; as if they do their debt will be bigger than the value of their home. This is known as negative equity.
If, as a first-time buyer, you need to go straight onto an interest-only deal, you need to ask yourself whether it is the correct decision, during these uncertain times, to be taking up a mortgage.
Secondly, many people sort out their mortgage and then forget about it. If you don’t convert your interest-only mortgage to a repayment mortgage as soon as financially possible, and you have not been paying into a repayment vehicle, there is a very real risk that you may get to the end of your mortgage term still owing all of the capital initially borrowed.
With an interest-only mortgage, there is no guarantee that you will have sufficient funds to pay off the mortgage at the end of the repayment period. You must monitor the performance of your repayment vehicle to check that at any time it is on track to cover the capital sum required in the future.
Back to the top
Other options
Change to a repayment mortgage later - This might be a suitable option if, say, your earnings are low now but are expected to be much higher in future - for example, when you’ve finished training or gained a professional qualification. Using an interest-only mortgage keeps your monthly payments down until you can afford the higher monthly payments of a repayment mortgage. But because you’re not paying anything off the amount you owe, you will probably end up paying more interest in the long run.
Use a lump sum from somewhere else - For example, using an inheritance or selling something such as another property or a business. This is usually a risky strategy - how sure are you that the inheritance will materialise; what happens if your business fails?
Sell the property to pay off the loan - This is only suitable if you won’t need to live in the property - for example, if it is a buy-to-let property or a second home, or you are buying something cheaper.
Back to the top
Our Recommendation
High prices in some areas, particularly London and the South East, mean that sometimes an interest-only mortgage can be cheaper than renting. While you may not be paying off the capital, you do have a foot on the property ladder. As long as you switch from interest-only to a repayment mortgage as soon as possible, then it can work.
Katie Moore, from Nationwide suggests shopping around before committing to any mortgage: “Each lender offers products with different interest rates, fees, flexibility and terms. Do your homework and compare deals to ensure you find the one that best meets your needs.”
She also advises first time buyers to save money to make a larger deposit: “Most lenders offer better deals to people with bigger deposits, so saving the extra money will be worth it.”
Compare mortgages, or work out how much you can afford with our Mortgage Calculator.
| 
