How does an Interest only Mortgage Work

A mortgage is a financial contract between the lender and the borrower. Mortgages are tailored to the individual and the precise terms and conditions given will be dependent on many different factors, such as the loan to value ratio, the amount of the mortgage and a whole range of other circumstances specific to each borrower. Yet despite this there are essentially two different types of mortgages which is the repayment mortgage and the interest only mortgage.

When a mortgage is advanced the borrower will not only have to pay back the principle sum, i.e. the amount advanced, but also an additional amount, i.e. interest, for having the privilege of the mortgage. The amount of interest is dependent on the interest rate, and the interest rate will depend on many factors. There will be an interest charge regardless of whether the borrower has taken on an interest only mortgage or a repayment mortgage.

Mortgages are usually paid on a monthly basis over an agreed number of years. If a borrower has taken out an interest only mortgage the monthly repayment will pay the interest charge only. If the interest rate is fixed, i.e. a specific percentage of the mortgage advanced, the monthly payment will be the same. If the interest rate is variable, i.e. subject to change during the duration of the mortgage, the monthly payment will fluctuate with every change in the base interest rate. Fixed rates are advantageous in that the borrower is certain of the specific monthly payment making it easier to budget, whereas a variable rate interest rate will be preferable when the base rate is on the decline or at a current low.

Since the monthly payment of an interest only mortgage only covers the interest charge the capital advanced, i.e. amount of the mortgage doesn’t decrease. This means that it is never paid off with the normal monthly payment. However, the mortgage will have to be repaid at some time in the future.

Since the interest only mortgage doesn’t change with each payment many may ask what is the point of them. The monthly payment of an interest only mortgage is often much less than that of a repayment mortgage and is likely to make it more affordable for a first time buyer. With an interest only mortgage a first time buyer can purchase a property, hence securing a foot hold on the property ladder, and wait for an ideal time when the property market picks up allowing the property to be sold for more than it was bought for which may result in a sizeable deposit for the next property. During this time the buyer is likely to want to change to a repayment mortgage to start paying off some of the capital. During this time a repayment mortgage is often more affordable than when first starting out.

Alternatively, an interest only mortgage is ideal for those people who already have a property but who buy a second property to rent out or let. The rent generated should cover the mortgage plus all other letting expenses although it is unlikely to generate much of a profit if any at all. When the time is right the land lord will sell the property for more than it was bought for, hence allowing the mortgage to be settled and leaving a nice profit through the capital gain. Rental properties should be seen as a long term investment and the best capital gains are usually made when the property is held for many years.

Before taking out a mortgage, regardless of whether it is an interest only or repayment, it is advisable to seek professional advice. A professional adviser will provide a range of options that will enable a borrower to assess and appraise a whole range of mortgages and choose the most suitable based on the individual’s specific circumstances.