What is an Interest Only Mortgage? A Comprehensive Guide

Would you like to learn about interest only mortgages? If so, you’ve come to the right place. In this comprehensive guide, I’ll explain what an interest only mortgage is, how it works, the benefits and risks of this type of this type of loan, and why you should consider it. I’ll also cover how to choose the right interest only mortgage, the different types of loans available, how to use an interest only mortgage calculator, and how to compare interest only mortgage rates.

Introduction: What is an Interest Only Mortgage?

An interest only mortgage is a type of loan that requires borrowers to pay only interest on the loan amount for a specific period of time. During this time, the borrower does not need to make any principal payments. After the interest-only period expires, the borrower must consider ways to clear the loan or move to another lender.

Interest only mortgages can help borrowers save money by reducing their monthly payments and providing healthier cashflow on rental properties. This makes them attractive to many investors. However, it’s important to understand the risks of an interest only mortgage before making a decision.

How Does an Interest Only Mortgage Work?

An interest only mortgage works much like any other mortgage. Whereas with a repayment mortgage, the borrower takes out a loan with a lender and agrees to pay back the principal plus interest over a set period of time, with an interest only mortgage, the borrower only pays the interest due on the loan.

For example, if the borrower takes out a loan of £200,000 with an interest rate of 5% and a 5-year fixed rate term, then on a repayment mortgage they would typically be required to pay roughly £1,170 per month in interest and capital payments. However, if they have an interest only mortgage, they would only need to pay £834 per month in interest payments.

At the end of the mortgage, the borrower will be required to make arrangements to clear the loan, but as it typically is for mortgage holders in the UK, the loan is usually refinanced after the initial (2-5 year) interest rate period comes to an end.

What Are the Benefits of an Interest Only Mortgage?

There are several advantages to taking out an interest only mortgage. The primary benefit is that it can help borrowers purchase a more expensive property than rent cover calculations would otherwise afford. This is because the interest-only payments are usually lower than the payments for a traditional mortgage.

Another benefit of an interest only mortgage is providing investors greater cashflow. This really comes into play if a fixed rate deal is locked in for many years and rent rises create a larger return on fixed mortgage outgoing.

Many lenders now take it as a given that mortgages taken by investors will be interest only, and as such have created many products to suit investors with different needs for flexibility or long term stability.

What Are the Risks of an Interest Only Mortgage?

While there are many benefits to taking out an interest only mortgage, it’s important to understand the risks as well. The primary risk is interest rates. Investors who take out a variable product will be more exposed to this risk, picking up rate rises during the term of the product, but also (benefits of) rate drops. For fixed rate product holders, the risk is if during the time of holding that product, the rate as increased substantially, and then when it comes to refinancing, seeing payments increase.

There is also the risk that the borrower could end up owing more than the original loan amount. This was seen in 2008 when some investors were lured into taking 100%+ mortgages on certain types of properties and in areas which did not stand up to the valuations when things came crumbling down.

Who Should Consider an Interest Only Mortgage?

I will re-emphasise that this should not be read as financial advice and you should always consult a qualified mortgage expert for advice on taking out a mortgage.

An interest only mortgage can be a great option for certain types of borrowers- i.e., investors seeking to maximise cashflow and minimise outgoings while not immediately considering paying off the capital.

It can also be a good option for those who want to move on from the asset after set period to walk away with capital gains as cashflow from rent payments.

How to Choose the Right Interest Only Mortgage

When choosing an interest only mortgage, it’s important to make sure that it is the right fit for your deal. Again a qualified adviser will be best placed to guide you, but below are some points to consider.

Fixed or variable: As the name states, some loans are fixed at a certain rate during the initial period, while others will fluctuate with bank interest rates. The interest rate environment and your need for flexibility will determine the best type for your specific needs.

Secondly, the length of the product. Most products in the UK have a 2-5 year ‘lock-in’ period in which you will be in an agreed (favourable) rate before moving to the lender’s (slightly unfavourable standard variable rate). Given the fees that get added to loans at each refinance, it can make more sense to go for longer periods each time and especially during times of lower interest rates.

Next, you should consider the interest rate. Different lenders may offer different rates, so make sure to shop around. Also, keep in mind that the interest rate can change over time for a variable product, so you should make sure to understand how the rate could affect your payments in the future. While lower rates can be tempting, also keep in mind any fees which might get added to the loan. While these may be out of sight, they can add to the balance

Finally, you should make sure to understand the terms of the loan. Make sure to read the fine print so that you understand any prepayment penalties or other fees that may be associated with the loan.

Interest Only Mortgage Calculator

An interest only mortgage calculator can be a useful tool for those who are considering taking out an interest only mortgage. This calculator can help you determine how much you would need to pay each month to cover the interest due on the loan. It can also help you determine how much you could save by taking out an interest only mortgage.

When using an interest only mortgage calculator, make sure to enter the loan amount, interest rate, term, and type of loan. Keep in mind that the calculator is only an estimate, so you should also speak to a lender to get an accurate estimate of your payments.

There are many free online calculators available, including this from the money saving expert website: https://www.moneysavingexpert.com/mortgages/mortgage-rate-calculator/

How to Compare Interest Only Mortgage Rates

When comparing interest only mortgage rates, make sure to consider the loan amount, interest rate, term, and type of loan. Different lenders may offer different rates, so it’s important to shop around. Also, make sure to compare the fees and other costs associated with the loan.

It’s also important to compare the terms of the loan. Make sure to read the fine print so that you understand any prepayment penalties or other fees that may be associated with the loan.

Conclusion

An interest only mortgage can be a great option for certain types of borrowers. It can help them stretch their borrowing, provide better cashflow and potentially more flexibility in managing their property. However, it’s important to understand the risks of this type of loan before making a decision.

When choosing an interest only mortgage, make sure to consider the length of the initial interest rate period, the interest rate, and the terms of the loan. You should also make sure to use an interest only mortgage calculator and compare rates from different lenders.

I hope this guide has been helpful in helping you understand what an interest only mortgage is and how it works. Good luck in finding the right loan for you.