Traditionally, Interest Only mortgages were arranged where borrowers had a savings plan to run alongside it (e.g. an endowment or ISA), which aims to provide enough money at the end of the mortgage term to repay the balance outstanding. So the monthly payments made to the lender with an Interest Only mortgage, just cover the cost of borrowing the money, they do not reduce the Capital balance (amount outstanding). Therefore the mortgage balance remains the same, unless you make extra payments towards your mortgage.
If you borrowed £100,000 on an Interest-Only basis, then you would still owe £100,000 after 25 years. This can be clearly seen in the diagram below.
Please note the graph below is for illustrative purposes only.
Interest Only graph
If you are only paying interest to the Lender, and therefore the debt is not reducing, you would need to make additional provision to repay the debt at the end of the mortgage term. This is how endowment policies became popular in the late 1980s. However, endowments are not the only plan that can be used with the aim of repaying an ‘Interest Only’ mortgage. Any investment capable of providing a lump sum equivalent to the outstanding debt has the ability of being used as a repayment vehicle, such as an ISA or the lump sum from a Pension plan. Some people use the expectation of money coming to them in the future, such as an inheritance, as a repayment vehicle for an Interest Only mortgage. Lenders generally will not accept this as a suitable repayment strategy, as the rules around inheritance could change, and therefore should not be relied upon.
With any investment related repayment vehicle, the caveats ‘investments can go down as well as up’ and ‘you may not get back the full amount invested’ apply. There is also no guarantee that the investment taken out will be sufficient at the end of the mortgage term to repay the mortgage, so regular reviews are essential.
In addition to your ‘repayment plan’, your mortgage payments are not the only expense you need to consider. You will also need to consider Buildings and Contents insurance; Life Cover and Critical Illness Cover; Mortgage Payment Protection and Redundancy Cover.
For friendly, plain speaking advice contact one of our expert mortgage advisers today on 01271 346123.