Interest Only Mortgages involve the borrower only repaying the loan interest until the end of the mortgage term. Because you do not repay the capital debt, the mortgage amount remains the same.

Advantages

Payments are lower because you are not paying off the capital debt part of the mortgage. This gives you the opportunity to increase your borrowing capacity. As well, monthly repayments are much lower than capital and interest mortgages.

Disadvantages

Because your monthly payments only cover the interest on the mortgage, you will need to make separate financial investments to pay off the loan when the term ends. If you do not, your home could be repossessed. By the end of the term, if you have made sound financial investments, you should have accumulated enough cash to pay off the capital debt.

In the United Kingdom in the 1980s and 1990s, a popular mortgage for homebuyers was to combine an interest-only loan with an endowment policy, known as an endowment mortgage. The endowment policy was supposed to cover the mortgage. Because they were poorly managed, and failed to deliver the promised amounts, these endowment policies became unpopular. More recently, there has been an increase in the number of interest-only mortgages where people are not investing to repay the capital loan. Instead, they count on rising house prices so they can acquire a smaller property and use the difference to pay off the mortgage. This is an extremely high-risk tactic and not recommended.

Options to Repay the Capital Debt

There are a number of options to repay the capital debt. You could make another payment in an investment such as an Individual Savings Account (ISA) or an Endowment. At the end of your mortgage term, the accumulated funds would pay off the capital debt. One factor to take into account is that £100,000 in 25 years time will not be worth the same as today. This is due to inflation. Therefore, the amount you need to save over the 25 years is still £100,000, but it is much easier to save that money in about the last 10 years of the mortgage term. One way of doing this is to buy a low-risk fund such as an index tracker. An index tracker is a method of following how well a stock is performing. When the 25 years are up, you have already paid off the interest, and you simply pay the required amount from your ISA to pay off the capital

Considerations

It is important that you keep up to date about the amount of money contributed each month in your investment fund. If there is a shortfall at the end of the term, it is your problem, not the lenders. If you cannot pay it back, they will take your home. If your investments do well, you may be in a position to pay off the mortgage early. If you choose an interest-only mortgage, it is crucial that you monitor the progress of your investments. You may need to increase the amount you put away each month if they are not growing as expected. If you are not comfortable with this method then choose the repayment mortgage option.