As more interest-only deals come onto the market and more homebuyers enquire about them, we take a look at whether these mortgages offer a good deal.
More than six out of every 10 mortgages are now available on an interest-only basis, offering increased choice to borrowers looking to cut their costs.
The number of residential mortgages currently offered with an interest-only option is up to 61%, compared to 48% in March, according to financial information group Moneyfacts.
Mortgage products are usually repayment or interest-only and the shift towards offering more options to switch to interest-only might show how lenders are responding to the financial hardship caused by the coronavirus pandemic.
Legal & General Mortgage Club reported a significant rise in broker enquiries about interest-only options between April and May.
“An interest-only mortgage could be a viable option for borrowers who have suffered financially as a result of the coronavirus pandemic,” says Rachel Springall, finance expert at Moneyfacts.
“Borrowers may well be seeking ways to reduce their monthly expenses, and an interest-only mortgage could do just that.”
What is an interest-only mortgage?
If you have an interest-only mortgage you only pay interest on the amount you owe each month, you do not repay the debt.
By contrast, with a repayment mortgage, some of the money you repay each month covers the interest payment and some of it is used to reduce the amount that you borrowed.
The market for pure interest-only products (ie mortgage deals that are not also offered on a repayment basis) remains niche, with just 77 mortgages, or 3% of all deals, offered on this basis.
What are the advantages of an interest-only deal?
The main advantage of an interest-only deal is that the monthly payments are significantly cheaper than a repayment one.
For example, monthly payments on a £200,000 mortgage at 2.5% interest would be just £417 on an interest-only basis, compared with £905 on a repayment one.
As a result, the deals may appeal to people who have suffered a short-term drop in their income, or those who need to buy a property in an area that would be too expensive for them on a repayment basis.
Interest-only mortgages are also typically taken out by buy-to-let landlords to reduce their monthly outgoings.
What are the downsides of having an interest-only mortgage?
The most obvious downside of an interest-only loan is that you are not reducing the amount you owe each month.
As a result, while you would own your home outright at the end of a typical 25-year term if you had a repayment mortgage, with an interest-only loan you would still owe exactly the same amount as you did when you first took out the deal.
Although interest-only mortgages mean cheaper monthly payments, they are more expensive over the long-term because you are not reducing your debt.
So, while you would pay a total of £69,204 in interest on a £200,000 repayment mortgage at 2.5% over 25 years, you would pay £125,055 on an interest-only one.
Another thing to bear in mind is that lenders usually require people who are on interest-only mortgages long-term to have a credible repayment plan for the outstanding debt they owe, such as paying a set amount each month into a savings account.
If you do not have a realistic way to eventually clear the debt, you are likely to be refused one of the loans.
In the past, it was popular for people to take out interest-only mortgages and invest the money they would have used for repayments into shares. But this is now considered to be a high-risk strategy and the plans were the subject of a significant mis-selling scandal.
Are interest-only mortgages ever a good idea?
Interest-only mortgages have seen a significant fall in popularity in recent years, with the number of people on one of the deals halving since 2012.
But there has been a resurgence in interest in them since the coronavirus pandemic struck with interest-only deals the third most searched-for option by mortgage brokers during the first week of May.
Although interest-only deals are not a good long-term option for most people, they can be useful in the short-term.
For example, if you have suffered a temporary drop in your income due to coronavirus, switching to an interest-only mortgage for a short period of time may enable you to keep up with monthly payments.
It may also be worth considering an interest-only loan if you are coming to the end of a mortgage payment holiday but still cannot afford to make full repayments, or as an alternative to taking out a repayment holiday.
But it is better not to consider an interest-only mortgage just to help you buy a more expensive property.
Instead, you could consider other ways to reduce your monthly repayments, such as opting for a mortgage term that is longer than the conventional 25 years or saving a larger deposit, which would enable you to qualify for a lower mortgage interest rate.
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