With the difficulties these days in getting mortgages and the high costs associated with obtaining a mortgage, this article looks at the interest only option loans which are enabling people to gain a mortgage and the advantages and disadvantages associated with this option.
Confidence in the UK housing market has rebounded since the 2008 financial crisis, with financial institutions lending out more mortgages with increasingly competitive terms and conditions. According to the Telegraph, this rebound is partly attributable to the return of interest-only mortgages. Interest-only mortgages allow for greater flexibility than traditional repayment mortgages; however they do come with a set of risks and conditions that potential homebuyers should be aware of beforehand. While these loans allow individuals to buy mortgages that are better suited to their needs, such loans also require greater planning and fiscal responsibility on the part of the borrower. This article will look at what interest-only mortgages are, what their advantages and disadvantages are, and how individuals should manage their finances if they choose to take out an interest-only mortgage.
Interest-only vs. Repayment
With the more common repayment type of mortgage, borrowers make monthly payments that go toward paying down both the capital of the loan as well as the mortgage. Interest-only mortgages, however, are slightly different, as they allow borrowers to pay only the interest of the mortgage each month. The capital will still need to be paid down, but not for a certain period (typically two to five years), during which only the interest needs to be paid.
Advantages of Interest-only Mortgages
The advantage of an interest-only mortgage is that, at least for the interest-only period, monthly repayments tend to be much smaller than they would be for a repayment mortgage. These smaller payments allow individuals to save money during the interest-only period, money which can then be used to pay down the capital of the loan later on. As such, for those who are looking to buy a house today, but are not quite yet able to make the large monthly repayments that a repayment mortgage demands, then an interest-only mortgage could be ideal.
Disadvantages of Interest-only Mortgages
Interest-only mortgages come with a number of disadvantages, however, that borrowers should be aware of. In many instances, borrowers invest their savings during the interest-only period in stock funds or Isas in order to put the money they make from these funds towards the capital of their mortgage later on. If these funds do not perform well, however, borrowers may find it difficult to repay the capital of their loan. Additionally, getting approved for an interest-only mortgage tends to be much more difficult than it would be for a repayment mortgage. Most banks will demand a much higher deposit for an interest-only loan than they would for other types of loans. While interest-only mortgages are making a comeback, it is important to know that they are still considered highly risky for lending institutions, thus many banks refuse to grant them outright. Finally, while the monthly payments for an interest-only mortgage are low to start with, over the life of the loan borrowers will often end up paying more in interest since they are still paying the interest on the full capital.
How to manage an interest-only mortgage
Paying down an interest-only mortgage requires prudent financial planning. As mentioned, many borrowers choose to invest money in stocks or Isas which they then put towards the capital of their mortgage when the interest-only period ends. While this is certainly a wise decision, borrowers should have a backup plan in case those investments do not perform as well as expected. While the low initial monthly payments are attractive to many borrowers, being realistic about whether one’s own income will be sufficient to cover the monthly repayments once the interest-only period ends is imperative. Additionally, since the entire capital will still be owed during the interest-only period, it is a good idea to protect one’s family from having to repay that capital in the event of one’s death. As such, taking out a life insurance policy that covers the same term as the mortgage can help safeguard family members from having to pay down the entire mortgage should the borrower pass away before the end of the loan’s term.
An interest-only mortgage offers great financial flexibility and lower monthly repayments during the first few years of the mortgage term, making it an attractive option for those who want to buy a mortgage today but do not yet have the financial means of making large monthly repayments. These mortgages, however, are highly risky and come with strict approval requirements, meaning borrowers need to be able to plan for their financial future for years ahead.
Reference
‘Return of the interest-only mortgage.’ Telegraph. telegraph.co.uk/finance/personalfinance/borrowing/mortgages/10254687/Return-of-the-interest-only-mortgage.html
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