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What is an interest only mortgage?

For most people, getting a mortgage is one of the most important financial decisions in their lives. When you start to look for the best mortgage, you will see hundreds of mortgage products with different names and associated mortgage deals and interest rates. As a borrower, it is important that you understand the different types of mortgages so you can choose the mortgage that is best suited for you. In this suite of mortgage guides, we look at the different type of mortgages available in the market.

Previously we discussed repayment mortgages, in this mortgage guide, we will focus on interest-only mortgages.

interest-only mortgages are a 'type of mortgage' that are based on repayments are based purely on interest.

Interest-only mortgage

With an interest-only mortgage, your monthly repayments will comprise only of interest. The monthly repayments are lower in an interest-only mortgage as compared to a repayment mortgage as the monthly mortgage repayment does not contain any funds which will be used to repay the mortgage.

Example: Let's say you take an interest-only mortgage of £250,000 for 25 years at an annual APR of 4.9%. Your monthly repayment will be £1,021, which is lower than the monthly repayment of a repayment type mortgage for a similar loan amount. At the end of 25 years, you would have paid a total of £306,250. However, because it is an interest-only mortgage, your entire repayment comprised of interest, and you will still owe the original £250,000 to the lender.

As per new mortgage lending rules announced in April 2014, lenders are allowed to provide interest-only mortgages only to borrowers with a solid repayment plan. If you need an interest-only mortgage, you will need a savings plan for repaying the original loan amount.

Between the two methods, repayment is a better option. One, it is difficult to get an interest-only mortgage. Even if you get one, an interest-only mortgage is not recommended. Ideally, it is good to have a debt repayment plan for both types of mortgages. But with a repayment type mortgage, even if you don't have a repayment plan and you simply make your monthly repayments regularly, you can be debt-free at the end of the term. Also, your interest liability starts reducing as the debt is reduced every year.

Advantage of fixed rate mortgages

  • Your monthly mortgage payments will be lower than other mortgage products
  • You can invest the sum that would have been used for repayments in a savings plan that affords higher rates of interest than you would achieve by simply repaying the mortgage

Disadvantages of fixed rate mortgages

  • You don't own your home at the end of the agreement, you must set aside funds to repay the mortgage or move out and have no assets to show for the period.
  • If your savings plan does't achieve the interest rates required you may fall short of repaying the mortgage and need to fund the final mortgage repayment separately or be forced to sell the property.

Conclusion

Depending on your preferences, you have many mortgage options. Use our Mortgage Calculator to calculate the monthly mortgage repayments and total repayment for mortgages at different interest rates and different loan terms.

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