Interest-only mortgages could be set for a comeback as the Financial Conduct Authority (FCA) considers reviewing lending rules to help boost the economy.
The mortgage was once “far more popular”, said ThisIsMoney, until “stricter regulations” in the aftermath of the financial crisis restricted lending.
But interest-only mortgages are “overdue for reconsideration”, said Malcolm Davidson of UK MoneyMan in MortgageStrategy.
What is an interest-only mortgage?
As the name suggests, with an interest-only mortgage you repay only the interest, rather than full monthly repayments, on a loan, said The Telegraph. You will also need to “prove you have a plan” to repay the remaining capital once the loan term ends.
That plan typically involves “savings, investments, pensions, sale of property” or changing to a “different type of mortgage”.
Before the 2008 financial crisis, said ThisIsMoney, interest-only mortgages were “synonymous with irresponsible lending and reckless borrowing”.
This led to tougher FCA rules on mortgage affordability that were introduced in 2014 and now fewer than one million borrowers have interest-only loans.
But Davidson said today’s mortgage market is a “different place” and interest-only lending could play a “valuable role, particularly for borrowers aged 55 and over”.
The product can now offer flexibility, said James Pagan, director of product and portfolio at April Mortgages in Mortgage Solutions, as they could give borrowers “greater control of their monthly outgoings, and the opportunity to manage cash flow and plan effectively for the future”.
How does an interest-only mortgage work?
When you buy a home with this type of mortgage, you will only repay the interest each month but, said Experian, you will still owe the same amount you initially borrowed “so you’ll need to either pay it back or remortgage your home”.
Ultimately, your monthly payments will be lower compared with a repayment mortgage, said Habito, “but you won’t make a dent in the loan itself”.
What are the pros and cons of an interest-only mortgage?
A benefit of interest-only mortgages is that borrowers can make lower payments initially, said Experian, “and pay more when their income or savings increase near the end of their mortgage term”.
The “biggest drawback”, said Unbiased, is that you need to have a way of paying the loan back at the end and “you can’t just forget about it”.
Additionally, the total amount you repay will end up being “much higher” than a repayment mortgage as the interest is calculated on the same overall loan amount being paid rather than the capital going down in value.
Alternatives to interest-only mortgages
As an alternative to interest-only, most borrowers are likely to be on a repayment mortgage where, said Habito, you “steadily pay back” the loan along with interest on “however much capital you have left”.
Once the type of payment is decided, there are two main types of mortgage to choose from, said Which?. These are fixed rate deals that “guarantee your rate for a set number of years”, and variable rate or tracker deals where your rate can go “up or down depending on economic conditions” and interest rate movements.
Whichever mortgage and payment plan you use, said Experian, consider how they “fit your present and future needs”, the risks involved and “how you will afford the repayments”.