Interest only mortgages

Interest-only mortgages

When you take out a mortgage, you undertake to pay back the original sum you borrowed known as the capital plus interest.

There are two ways of doing this. As a:

• Repayment mortgage (also know as capital and interest)

• Interest-only mortgage

The repayment mortgage option

With a repayment mortgage, the monthly payments are made up of interest and a portion of the capital debt.

This means that, provided you keep them up to the end of the mortgage term, you are guaranteed to clear what you owe.

The interest-only mortgage option

As the name suggests, with an Interest-only mortgage, the monthly payment includes only this element of the debt.

The upside of this is that the monthly cost is considerably lower than for a comparable repayment mortgage.

The downside is that at the end of the mortgage term you still owe the original amount you borrowed.

And if you can't repay it, your mortgage lender is perfectly entitled to repossess your home.

that's why, if you go for this option, you need to organise a way to repay the capital debt.

Unless you can be certain of a sizeable inheritance or other windfall, this means saving as you go along. There are several ways to do this

Repayment vehicles for the capital debt

• An endowment: This is a stock market-based investment plan. These are now recognised to be very risky and, therefore, should be avoided.

To find out why, read The endowment mortgage and What went wrong with endowments?

• A pension plan: It's also technically possible to use cash from a pension plan to clear the debt, but this is also a very bad idea.

For an explanation of this, go to How a pension mortgage works and The dangers of a pension mortgage.

• An Isa: Isa stands for individual savings account and this is a type of tax-free investment. It's generally considered to be the best repayment option.

To learn more about these, see The Isa mortgage.

Get impartial advice

Whatever repayment vehicle you go for, it involves making a substantial, long-term financial commitment.

that's why it's essential to discuss your options with an independent financial adviser who specialises in investment before making your choice.

A word of warning

Opting for an interest-only mortgage involves accepting a significant degree of risk.

If your repayment vehicle doesn't perform well, you could be left without enough cash to clear your debt.

If worrying about this will keep you awake at night, choose a repayment mortgage instead.

And another thing

The majority of mortgage providers no longer ask for proof that you have set up a suitable savings or investment plan before agreeing to an interest-only mortgage.

But don't let this tempt you into going without one if you don't have enough money put aside when the time comes to repay your lender, you could lose your home.

To read more on this subject please see the list below or your mortgage guide or your home buying guide

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