Your interest only mortgage - our step-by-step guide

Sarah Coles
house cloud in hand
house cloud in hand

Interest only mortgages appeal to anyone who is struggling to afford a repayment mortgage, because the monthly payments are considerably lower.

It's for this reason that before the financial crisis, they made up one in three of all new mortgage deals. However, the last seven years has taught us a lot about interest-only deals, which is worth understanding before you consider getting one.

What is interest only?
With a repayment mortgage, every month you are paying the interest on your loan, and a slice of the original sum you borrowed. They are designed so that by the end of the mortgage term you will have paid back all the money you borrowed in order to buy your house. With an interest only deal, you will only ever pay the interest on the loan. At the end of the mortgage term you will still have to pay back the sum you initially borrowed.

Why have they fallen out of favour?

When these deals were first introduced they were sold alongside endowment policies. These were investment vehicles which you paid into every month, and were supposed to grow in value to be large enough to repay the mortgage at the end of the term.

The idea was that the combination of the amount you paid in mortgage interest, plus the amount you paid into the endowment, was lower than the equivalent cost of a repayment mortgage. At the same time, there was a chance that if they performed particularly well you'd get an additional windfall at the end of your mortgage period.

The problem was that endowments were very poorly understood. Many people didn't realise they were taking a huge risk, and that there was a good chance that their endowment wouldn't grow fast enough during the term to be big enough to repay the debt at the end of it - so they'd still be saddled with a portion of the debt.

As people gradually came to understand the flaws in endowments, and the real risks they involved, they fell out of favour. However, interest-only mortgages continued to flourish.

The problem was that one in ten people weren't taking out any kind of savings or investment vehicle to enable them to repay the debt at the end of the term. Instead they were taking a huge gamble that their property would have risen enough in value for them to sell it, pay off the debt, and be able to afford something new.

The experiences of the last seven years have revealed quite what a gamble this is - with many areas still not seeing prices peak above 2007 levels. And the mortgage lenders are wise to it too. It has meant many have steered clear of them entirely - with the number on offer falling from 82 in 2007 to 12 today. Meanwhile, others have introduced tougher rules and higher interest rates.

Get a Mortgage, Receive a Cat — Only in Russia
Get a Mortgage, Receive a Cat — Only in Russia

Can you still get one?

There are still some deals available. However, in many cases the interest rates charged on them are far higher than the repayment alternatives.

In addition, in order to qualify, you will need to pass some stringent tests. The Financial Conduct Authority's Mortgage Market review means that anyone who gets an interest only mortgage needs to be able to prove they have a sensible strategy for repaying the debt at the end of the term. And when the lender looks at your strategy they are likely to take a harsh view of that too. So, for example, some lenders won't consider cash in the bank as an asset, while others refuse to assume that your investments will grow at all over 25 years.

Other lenders will require you to earn at least £75,000 a year in order to qualify, and some won't lend more than 50% of the property price.

It means that this kind of mortgage is not suitable for the majority of borrowers. However, there are some people for whom they can still be useful. So, for example, in some areas, it's cheaper to buy a home with an interest only mortgage than it is to rent. You are running a risk here: if the value of the property falls while you own it, you'll be worse off overall, and if you need to sell up you'll be left with a debt to repay. However, if the value of the property rises, you can switch to a repayment mortgage or sell up and you're better off.

What if you currently have one?

The new rules have created something of a headache for people currently on interest only deals. Some have signed up to mortgages with discounted rates or a fixed rate for a few years. When their deal came to an end they reverted to a much higher interest rate (the SVR). But when they came to try to get a new mortgage on a better rate, many found that under the new rules they couldn't qualify for an interest only mortgage, and they would need to switch to a repayment deal. This had a profound effect on their monthly outgoings.

The situation is particularly difficult for older borrowers, because those over the age of 60 are usually unable to extend the term of their mortgage, so they have to repay the entire sum in the few years they have left to run on their current deal. It means their monthly payments can be up to ten times higher.

Some lenders will be flexible, and will convert some of the deal to a repayment mortgage and keep some as interest-only. However, in some cases, borrowers have no alternative but to sell up and downsize.

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