Mortgage market is an interesting place. There are many products available to pick from. I recently covered tracker mortgages. Today I want to share more information on what is an interest only mortgage.
Not all mortgage types are the same. It is also true that not all of these will work for everyone. Interest only mortgage is one of these products – it is worth knowing about it however it might not be right for you.
Interest only mortgages are more often than not linked to investment type of properties.
what is an interest only mortgage
When it comes to buying a property – mortgage is the word you certainly hear. One thing that many don’t even consider – it is a repayment mortgage that people are mostly talking about. There is however another type of mortgage to be aware of.
The alternative is called an interest only mortgage. As the name suggests – you are only expected to pay the interest. The balance that you owe does not get reduced.
As a result, at the end of the term of your mortgage you are still expected to repay the full balance that you initially borrowed. This is the exact reason this type of mortgage is mostly linked to buy-to-let type of properties. This is where the landlord wants to create a cashflow.
What the landlord will plan to do at the end of the deal is either get a new mortgage for the property or try to sell it. The expectation here often is – properties keep increasing in their value. At the point when I need to sell – the property will be more expensive than it currently is.
This way the landlord gets to benefit from both – the asset appreciation as well as net positive cashflow.
The big selling point to the investors is the fact that their monthly payments are significantly less than the rent they are able to collect from the tenants.
People looking to buy a property to live in mostly will not be able to get an interest only mortgage. They would be expected to have a large deposit as well as proof that they will have a way to repay the initial balance at the end of the mortgage.
what do numbers actually look like
With your normal repayment mortgage you pay a set amount every single month. This however consists of 2 parts that you probably are not aware of. Part of the payment is interest on the balance you have. The other part is repayment of a part of the outstanding balance.
As the time progresses – your payment stays the same while the proportion of interest to the actual repayments decreases. As an example – if you pay £1,000 mortgage a month you might pay £900 of interest to start with and only £100 will go towards your own capital.
The last month will be a contrast – it will be £50 of interest payment and £950 going towards your own capital.
With interest only mortgage your monthly payments are also consistent through the life of the mortgage. Also, they are smaller than the payments you would make on your repayment mortgage.
The numbers above were just an imaginary example. An actual example could look like following:
- Mortgage balance = £300,000
- Mortgage term = 20 years
- Interest rate = 5%
- Repayment mortgage monthly payment = £1,980
- Interest only monthly payments = £1,251
As you can see – the difference is over £600 every single month. For an investor – that’s a large bump in their profit. For an actual homeowner this will end up costing a lot when the mortgage comes to its end.
is interest only mortgage cheaper in the end?
One might say – clearly the interest only mortgage is cheaper based on the numbers above. The above numbers don’t tell the full story though.
After the 20 year mortgage term comes to an end – the person who payed the £1,980 per month will own the full value of the property. The person who saved themselves £600 every month will have to find £300,000 to settle the balance.
The easiest way to see which product is actually cheaper – compare the full value of both mortgages.
Firstly, the repayment mortgage will cost you a £1,980 per month for 20 year period. The sum of this comes to £475,200. This means that you would pay £175,200 in interest over 20 year period.
Now, let’s compare this to an interest only mortgage. This will cost you £1,251 per month over 20 years. At the end of the term you will still owe £300,000 you started with. The total will come to £600,240.
As you can see – this would actually result in you paying over £300,000 in interest. On top of that – you would need to find a similar amount to repay the capital you have borrowed.
The above scenario however makes more sense for an investor who only looks to generate himself a cashflow and actually benefit from flipping the property at a later date.
The fact that they could benefit from additional £600 every month would allow them to buy their next investment property at a significantly sooner date.
summary
Interest only mortgages aren’t for everyone. Many banks will not even offer these to regular borrowers. An exception might be if you are a high net worth borrower with a large enough deposit.
The real benefit comes in the instances when you have options to generate more value from the monthly saving you are making. This way you are able to benefit both ways – you pay less every month while at the same time your money gets to work hard for you.
For those looking to own their property after the mortgage term comes to an end – repayment mortgage is the way forward. You do end up paying more monthly however the whole property is yours on the other side of this.
If you are interested in seeing what the numbers could look like for you personally – this calculator could do the job easily for you.
If you get an interest only mortgage – you should plan for your exit strategy early. Make sure you know how to accumulate the value that the lender will expect you to have available when the mortgage comes to an end.
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