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Should I switch to an interest only mortgage?
May 17, 2024

As mortgage rates have increased, many people have explored different options to try and keep their monthly payments as low as possible.

Should I switch to an interest only mortgage is a question that has been asked more in recent times, especially in light of the Government backed Mortgage Charter scheme. However, caution must be exercised if you are considering this approach.

What is an interest only mortgage?

In simple terms, an interest only mortgage is an arrangement where your monthly repayments consist purely of interest and don’t include any capital element at all.

This will result in a lower monthly payment when compared to a repayment mortgage. However, it also means that at the end of the term, you wouldn’t have paid any of the original mortgage balance off and would be expected to make a lump sum payment to clear the loan.

Why would anyone want an interest only mortgage?

Interest only mortgages are designed for people who have a credible repayment strategy for the end of the mortgage term.

For example, this could be by using pensions or investments. In this instance, they may prefer to retain the funds that would otherwise be used to repay the capital on the mortgage and invest them instead.

Some people may also decide to sell their property and downsize at the end of the mortgage term.

What are the disadvantages of an interest only mortgage?

Following on from the above, there are obvious risks involved with interest only mortgages.

For example, if you plan to use pensions or investments, what happens if there is a shortfall due to investment performance? What happens if you need to retain pension funds for income in retirement?

If you are planning on downsizing, what happens if you change your mind later on? What happens if you can’t sell when you need to or at an acceptable price?

You may be forced to sell if you don’t want to. This could mean moving out of your home at a time of life where this is the last thing that you would want to do.

In addition, on the purely financial side of things, the total amount of interest you pay to a mortgage lender for an interest only mortgage is usually much higher when compared to a capital and interest (repayment) mortgage at the same rate and over the same term.

In short, interest only mortgages are intended for people with credible repayment strategies who fully understand the risks involved. They are NOT designed for people who just want ‘cheaper’ monthly payments.

2024 – In the Real World

Having said all of this, there is no doubt that the sharp increase in interest rates has affected everybody. Some more than others.

Moving a loan on to interest only has provided much needed breathing space for people who may have been facing (or experienced) the payment shock involved with switching to a mortgage rate which is far higher than they are used to.

This was the reason for the Government backed mortgage charter scheme. This allowed some borrowers to move their loans onto interest only for 6 months to allow them more time to adjust their finances accordingly.

After the initial 6 months, the mortgage payment would go back to a capital and interest basis, usually with an adjustment to allow for the capital not paid in the previous 6 months, with no affect on a person’s credit score.

Is it worth changing to interest-only long term?

If you are considering switching to interest only to reduce monthly outgoings as a longer term plan, you need to exercise extreme caution and fully understand the risks. It’s usually a good idea to consider all other options first.

For example, could you extend your mortgage term? Is it worth looking at alternative mortgage lenders to get a better deal? Do you have funds you could use to overpay your mortgage?

There are pros and cons to each of these options, but the point is you should consider all of the alternatives available to make sure you do what’s right for you in terms of your individual circumstances and your risk profile.

If you feel that interest only is the way forward for you, it may be sensible to consider putting part of the mortgage on interest only and part on repayment (known as ‘part and part’). This will ensure that you will continue to repay some of the mortgage balance and could lower the future downside risk in terms of the long term repayment strategy.

You must make sure that you carefully consider your repayment strategy and ideally some contingency plans. Make allowances for what happens if things don’t work out entirely as planned so that you are fully prepared for each outcome and avoid unwanted surprises.

Whatever happens, make sure that you consider all of your options, all of the alternatives and know all of the facts and risks before considering interest only as a long term plan.

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