For many people, the Covid pandemic has brought unexpected changes to their financial circumstances. Some have been placed on furlough or made re
For many people, the Covid pandemic has brought unexpected changes to their financial circumstances.
Some have been placed on furlough or made redundant, while others will just want to be more cautious when it comes to their monthly budget.
Taking out an interest-only mortgage is one way to reduce your outgoings in the short term. But is it ever a good idea for homeowners, or is kicking the can down the road too much of a risk?
An interest-only mortgage could be a viable option for borrowers who have suffered financially as a result of the Coronavirus pandemic to reduce monthly mortgage payments
Popular with buy-to-let landlords, interest-only mortgages have become something of a taboo for owner-occupiers ever since the 2008 financial crash.
‘Many people used interest-only in the past as a way of making sure they could actually afford the mortgage in the first place, and deferred worrying about how they were going to pay it back,’ says Andrew Montlake, managing director at mortgage broker, Coreco.
‘It should never have been possible for someone to borrow 90 per cent of a property’s value on the basis they would pay the loan back by selling it later on down the line – what happens if that property then depreciates in value?’
In a year that saw total mortgage products drop by more than 40 per cent, ‘interest-only’ deals increased in 2020.
There are 200 specific ‘interest-only’ products available to homeowners as of January this year, up from 185 at the beginning of 2020, according to financial information website Moneyfacts.
In total, 63 per cent of available mortgage deals now allow for an interest-only option. Just a year ago, that figure was 50 per cent.
The days of 85 and 90 per cent interest-only mortgages are well and truly over according to Montlake, but will continue to be readily available for mortgages covering between 50 and 75 per cent of a property’s value.
What is an interest-only mortgage?
With an interest-only mortgage, you will only pay the interest each month, with the loan amount remaining the same.
This differs from a typical repayment mortgage where you will pay back a part of the loan, as well as the interest, each month until you eventually pay off the mortgage.
With interest-only, your monthly payments will be lower – but at the end of the mortgage term, the full amount you borrowed will need to be repaid in one lump sum.
Most mortgage deals allow borrowers to make overpayments of 10 per cent of the total mortgage amount each year without incurring penalty charges.
This means that, in theory, you could use an interest-only mortgage and still pay off the debt in lump sum payments spanning over 10 years or more.
Who is eligible for an interest-only deal?
The challenge for borrowers seeking an interest-only mortgage for their own home is that they are subject to much stricter lending criteria.
‘Typically, lenders require interest-only borrowers to have larger incomes and higher levels of equity in their property,’ says Alex Winn, mortgage expert at Habito.
The key issue for most lenders is how a borrower plans to pay back the mortgage.
‘If you can prove you have sufficient cash or stocks and shares then this will be acceptable for most lenders,’ says Chris Sykes, a mortgage consultant at Private Finance.
‘Equally, you might have another property you can sell in the future which can act as your repayment vehicle.’
But the most popular option is to pay off the mortgage via the sale of your property at the end of the mortgage term.
‘For this to be considered,’ says Montlake, ‘downsizing at the end of the mortgage term must be shown to be a viable option.’
Most lenders require a minimum equity level in the property of £250,000 or £300,000 – although there are some lenders willing to allow as little as £150,000, with others basing it on the post code you live in and the property prices in that area.
Most lenders will also require you to have a minimum income, often £75,000 for a single borrower and £100,000 for joint borrowers. However, there are some that don’t have a minimum income requirement at all.
Some lenders will allow you to borrow up to 50 to 60 per cent of the value of property on an interest-only mortgage, with any remainder on a repayment basis up to a maximum of 75 or 80 per cent of the property’s value.
When should you consider going interest-only?
An interest-only deal with a mortgage debt of £200,000 and an interest rate of 2 per cent would cost £334 per month.
In comparison, a repayment mortgage with a debt of £200,000 and an interest rate of 2 per cent would cost £1,012 each month over a 20-year mortgage term.
‘There are plenty of reasons why people might use an interest-only mortgage,’ says Sykes.
Interest-only mortgages remain something of a niche among homeowners, whilst it is the norm for buy-to-let investors
‘If you are someone who earns a large proportion of your income from bonus or commission then interest-only might be a good option.
‘You can use an interest-only mortgage to keep monthly repayments low, with a view to making large overpayments as and when you can.’
‘You might also want to enjoy having more available money for holidays or other activities, or perhaps it makes sense whilst you are paying school fees.’
Interest-only could be an option for equity-rich homeowners looking to remortgage or downsize in the future, or cash-heavy homebuyers.
Most lenders according to Sykes, will not offer an interest-only mortgage to a first-time buyer because they don’t want to be seen as lending irresponsibly to someone who hasn’t handled a mortgage before.
In any case, the larger deposit and high incomes often required mean interest-only mortgages are unlikely to be suitable for a first-time buyer.
What should borrowers be wary of?
Lower monthly payments might be the big temptation for many people, but it is also possible to lower the monthly costs of a repayment mortgage by extending the term.
An interest-only mortgage should only be considered as an option if a borrower has a viable repayment plan and understands the risks involved.
‘If your repayment method does not pan out, the lender will require its money back at some point – and in this instance, borrowers will need to sell the property in order to repay the loan,’ says Montlake.
‘For those borrowers who do have sufficient funds or a source of repayment, or high net worth individuals with various other assets, interest only can be a very credible option.
‘It is all about taking proper advice and going into any loan undertaking with eyes wide open and a full understanding of the risks involved.’
For all their benefits, an interest-only mortgages can lure borrowers into a false sense of security.
‘In the past, many people became accustomed to low monthly repayments and never had plans in place to repay the full loan,’ says Winn.
‘This is fine for a buy-to-let landlord, as it’s not their main home and they can sell it to repay the original loan back, but when it is someone’s own home, this becomes a problem.’