How do Interest only mortgages work?

An interest only mortgage is when your monthly mortgage payments only cover the interest owed. The capital borrowed needs to be repaid at the end of the mortgage term, usually from the proceeds of an investment policy.

As you are not paying off the capital the monthly payments are lower than a repayment mortgage. However it is worth remembering that you will need a lump sum of money in order to pay off the amount borrowed, meaning you need to consider the amount you’d need to save every month to do this.

Once your interest only mortgage ends lenders will expect you to have enough in savings to repay the loan. If you do not, and cannot afford to switch the mortgage to a repayment basis you may be forced to sell the property to pay back the debt.

In the past it was common for borrowers to take an endowment policy to repay their interest only mortgage, however due to poorer-than-expected investment performance many borrowers found their endowment policies did not provide enough to repay the outstanding debt. This meant that many people had to extend their mortgage term and keep paying the mortgage long after they expected it to be repaid.

If you have an endowment mortgage and are concerned about your policy falling short you can use our endowment shortfall calculator to work out the costs involved in changing some of your interest only mortgage onto a repayment basis

Changes in the market

The FCA estimates that by 2020 there will be 6m interest only mortgages due for repayment. Some of these have no set way to repay, and could risk being forced to sell their property. In many cases mortgages were offered to borrowers without requiring any proof of how they would pay the borrowing back

As part of the Mortgage Market Review criteria Interest only mortgages became tighter and lenders now require you can prove that you have a suitable method or strategy in place to pay back the debt.

So if you are considering an interest only mortgage, you must have a suitable way to clear the capital owed at the end of the term. This may include investment policies, such as ISA’s or endowment policies, pension lump sums, sale of other assets such as second properties or even in some cases downsizing.

You can talk through your mortgage options by speaking to our fee-free mortgage advisers who will help you choose the most suitable mortgage for your situation.

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