What are interest-only mortgages & are they friends or foes?

Interest-only mortgages have lower monthly payments, but they have other drawbacks to be aware of. Read more to learn about this unique kind of mortgage!
Are interest only mortgages a good idea?

If you’re starting the home-buying process, you’ve probably heard about interest-only mortgages. But you might not know how they work or if they’re right for your situation. 

Interest-only mortgages are a kind of home loan that you only pay interest on for a defined period. At the end of this period, you make a lump-sum payment on the principal. This is in contrast to a standard repayment mortgage, for which your monthly payment accounts for both interest and principal.

Related read: Mind over mortgage: saving for your first home

Here, we’ll dig deeper into interest-only mortgages, explaining how they work, what their benefits and drawbacks are, and sharing the typical eligibility criteria. Let’s get started!

How do interest-only mortgages work?

The interest-only period for interest-only mortgages is usually between 5-10 years. At the end of that period, you have a few options:

  1. Make a lump-sum or ‘balloon’ payment: This entails paying off the remainder of the mortgage principal, a huge payment.
  2. Refinancing to a repayment mortgage: This approach requires you to make monthly payments on a new loan, usually with significantly higher payments.
  3. Refinance with a large deposit: If you won’t be able to make the entire balloon payment but do have a significant amount of cash saved from the interest-only period, you may be able to refinance and make a larger deposit.
  4. Sell the property: At the end of the interest-only term, you can sell the home. If the home has appreciated during that time, this can work out well. However, if your home’s value hasn’t appreciated, you’ll need to cover the difference.

Regardless of what option you go for, having a detailed repayment plan in place is crucial. If you fail to meet the terms of your interest-only mortgage, your home could be repossessed.

Benefits and drawbacks of interest-only mortgages

Like any credit product, interest-only mortgages have a mix of benefits and drawbacks. Understanding these is essential for making an informed decision, so let’s take a closer look. 

Advantages of interest-only mortgages

Interest-only mortgages have unique benefits, including:

  1. Lower monthly payments: One of the main benefits is that they’re significantly more affordable on a monthly basis*. If you’re rebuilding your credit and improving your financial stability, this arrangement can provide much-welcomed breathing room.
  2. Flexibility with your budget: Because your monthly payments are lower on an interest-only mortgage, you may have more cash available to pay off debt and rebuild your credit score.
  3. Potential for home value growth: If your home’s value appreciates during the interest-only loan term, its value could exceed the mortgage principal you owe, giving you an advantage if you choose to sell. 

*Yes, but see below… 

Drawbacks of interest-only mortgages

Interest-only mortgages aren’t all upsides. Before taking any action like applying for one, be aware of the risks they entail.

  1. Higher long-term costs: While your month-to-month costs are lower with an interest-only loan, your loan could end up costing more in the long-run. There are two reasons for this:some text
    • First, you’re not building equity in the home during the interest-only period. This means that if your home’s value doesn’t go up (or even decreases), you haven’t gained any leverage through principal payments.
    • Secondly, if you don’t have the cash on hand to make the lump-sum payment, you’ll need to refinance your home. If you haven’t improved your credit score during this time, you could struggle to find a lender or face costly interest rates. This can cause you to pay more over time than you would have if you had started with a standard repayment mortgage.
  2. Market risks: If your home’s value decreases, you could find yourself in negative equity, meaning you owe more on the mortgage than your home is worth. This also makes it harder to cover the lump-sum payment by selling your home. 
  3. Eligibility hurdles: Most banks and lenders will be hesitant to extend this kind of financing to you unless you have a strong credit score. And in the event they do, your interest rates are likely to be higher, which can spell trouble in the long run. We’ll touch on eligibility more later. 

Is an interest-only mortgage right for you?

So you now know what an interest-only mortgage is, and what some of its benefits and drawbacks are. But is it right for you? Take these additional considerations into account before making a decision.

Your credit score impacts an interest-only mortgage

Lenders take a big risk with interest-only mortgages, as you’re not building equity in the home. Essentially, this means it’s harder for them to recover their losses if you’re unable to pay at the end of the term.

Therefore, your credit score plays a huge role in your ability to get an interest-only mortgage. This is primarily because lenders will look at your payment history — the factor with the biggest impact on your credit score — to determine how responsible you are with credit.

Additionally, your credit score will influence the interest rate you pay on the mortgage. The better your credit score, the lower your interest rate. That means that over the course of the interest-only mortgage term, a better credit score could save you thousands of pounds that can be reinvested for your upcoming lump-sum payment.

Eligibility for interest-only mortgages can be restrictive

The eligibility requirements for interest-only mortgages are often even more strict than those of repayment mortgages. Eligibility varies by lender, but the requirements typically include:

  • A high income: You’ll typically need to earn about £75,000 a year yourself, or have a combined income above £100,000 if you and a partner are applying together.
  • Having a repayment plan in place: Before you’re approved for an interest-only mortgage, you’ll need to have a repayment plan in place. This demonstrates how you intend to make the lump-sum payment at the end of the interest-only term. Repayment plans typically include things like savings accounts, investments, or pensions.
  • Having home-buying experience: First-time homebuyers often aren’t eligible for interest-only mortgages.

Related read: Six amazing side hustles that can boost your income

The bottom line on interest-only mortgages

If an interest-only mortgage isn’t right for your situation, we know how you’re feeling. It can seem like finding an affordable home and a financing solution is an impossible task. It’s frustrating, but keep your head up. Take the time to improve your financial standing:

  • Implement a budget and stick to it so you can see where your money is going.
  • Make all bill payments on time and in full to improve your payment history, demonstrating that you’re a reliable borrower.
  • Build your credit score by paying off existing debts like credit card balances, overdrafts, and car financing.

Pave helps you build your credit with ease

If you’re planning to buy a home, building your credit score can give you a major advantage. However, building your credit score can be confusing and complex. Where do you even start?

If you don’t know, start with the Pave app. Pave helps you:

  • Protect your credit score by monitoring your bills and upcoming payments. This way, you avoid missed payments that can seriously damage your credit score and stay in your credit report for six years.
  • Build your payment history with our credit-builder accounts*. Your payments are reported to TransUnion, Equifax, and Experian, actively building your credit score with three of the UK’s biggest credit reference agencies .
  • Learn about credit building tips and strategies so that you can take control of your finances. Expert support is available to members seven days a week via WhatsApp and email.

If an interest-only mortgage isn’t right for you, keep your head up and keep moving forward. Join the hundreds of thousands who have improved their credit score with Pave today!

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* Subject to approval. Pave cannot guarantee an increase in your credit score.