On paper, an interest only mortgage can seem more appealing than a conventional capital repayment mortgage as the monthly payments are lower. This is because you are paying just the monthly added interest but none of the original capital. If you are trying to stretch your budget, this may seem like a good short-term solution to being able to afford your dream home, but without an alternate means to repay the borrowing, you might just be delaying the pain and even exacerbating the problem of repaying what you borrowed.
The Financial Conduct Authority (FCA) recently established a working group with 12 mortgage lenders that will begin conducting market analysis to find out how many UK borrowers currently have (or once had) an interest only or part interest only mortgage with 'no clear plan/capability' to repay the mortgage at the end of the term. It will also look at those with such mortgages who don't have a plan or capital in place to repay at the due date. In 2022, it was estimated that about 1 million borrowers in the UK had interest only mortgages (excluding buy-to-let mortgages) - down from 2 million in 2015. However, according to the FCA, as interest rates and house sold prices have increased over the past two years, more borrowers may have switched to an interest only repayment schedule to help manage rising costs.
The History of Interest Only Mortgages
During the 1980s and 1990s, interest only mortgages were the preferred choice for buying a residential property, as well as chintzy floral wallpapers, bold statement colours and swagged curtains. Monthly interest payments were made in addition to depositing money into an endowment policy that was invested in the stock market. Borrowers were convinced that this investment would be enough to clear their mortgage at the conclusion of the term plus have some cash left over. However, due to turbulence in stock market values and other financial crises experienced during the 80s and early 90s, many homeowners came to realise that they lacked sufficient funds to repay their mortgage after the 25 year term. Furthermore, many people then said that they did not fully understand the policy they had been sold so there were substantial compensation payments made for mis-sold endowment policies.
Endowment policies then went out of fashion, but lenders continued to offer interest-only mortgages to borrowers and they represented an attractive option since they cost less to repay each month. In addition, in the 2000s, as house sold prices were increasing, many homeowners were reassured that there would be a big profit to repay the capital when their mortgage came to an end because by then, they would be able to sell their home - or, at least, that was the expectation. Some might also have bet on an inheritance or some other windfall to bail them out when the time came. All well and good and it might have worked for some, but, as life can be unpredictable, the risk remains that the funds won't be there at the end of the mortgage term to pay off the capital. In 2004 and 2014, new mortgage rules were introduced whereby mortgage lenders needed to gauge the affordability of an interest only mortgage and whether the borrower did indeed have a 'credible plan' to repay the loan at the end of their borrowing term.
What are the Problems with Interest Only Mortgages?
Your monthly debt does not decrease with an interest-only mortgage. For example, if you started the term with £200k in debt, you will end the term with £200k in debt.
You will have to make one large payment to pay off your mortgage at the end of the term. Selling your property is one way to accomplish this, but you'll also need to consider where you'll live going forward.
Although an interest-only mortgage may appear more affordable initially, you will ultimately pay more because you will be required to pay the entire interest amount each month in addition to a lump sum at the end.
Are There Any Situations Where an Interest Only Mortgage is Appropriate?
If you're in financial difficulties and wrestling with your mortgage payment, find out whether your lender subscribes to the Mortgage Charter, as it may grant you a right to temporarily shift from capital repayment to interest only. This would usually give you 6 months of interest-only repayments to help your financial situation stabilise. Upon expiry of the 6 month term, the loan will revert to a capital repayment basis. Furthermore, after six months, the capital sum that needs repaying will be higher and therefore monthly repayments will increase commensurately. So, while this might be helpful in case of financial difficulties, it may as well prove very expensive in the long term.
Another case where an interest-only mortgage is suitable is when you choose to finance a buy-to-let investment. You can repay the outstanding amount left after the term is completed once you sell the property as it gains in value. There are two major problems with this: finding a buyer and negative equity if house prices decline.
For more information on interest only and capital repayment mortgages, visit https://www.onedome.com/mortgages/mortgages-explained/. OneDome and CMME Mortgages are part of the same group, and OneDome acts as a referrer, directing customers to CMME Mortgages, which is an authorised and regulated mortgage provider under the oversight of the Financial Conduct Authority.
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