Interest-only mortgages can be a great option for self-employed borrowers and are still widely available.
But whilst they offer the benefit of cheaper monthly payments, they carry more risk for applicants and lenders alike. For that reason, eligibility criteria are stricter than for the equivalent capital repayment mortgage.
Read on to find out more...
What is an interest-only mortgage?
As the name implies, an interest-only mortgage is a secured home loan that, for the duration of the term, only requires mortgage interest to be repaid each month.
The amount borrowed, the capital, still has to be repaid at the end of the term as a single lump sum.
The method for repaying the debt itself is known as the repayment vehicle or repayment plan. Every lender has it's own list of acceptable repayment vehicles, with some providers more flexibile than others.
What are the advantages and disadvantages of an interest-only mortgage?
Unlike a capital repayment mortgage, where both the interest and a part of the capital are repaid each month, an interest-only mortgage doesn't pay off the sum borrowed during the term.
The biggest advantage of an interest-only mortgage, therefore, is the monthly payments are significantly lower.
Interest-only monthly payments vs capital repayment
As an example, on a £300,000 interest-only mortgage on a 25-year term and 4% interest rate, you'd only pay £1000 a month. On a capital repayment basis, the monthly mortgage payment is £1584, almost 60% more.
However, there are some drawbacks including:
- The original loan amount needs to be repaid as a lump sum at the end of the mortgage term
- Interest-only mortgages are more expensive overall as more interest is accrued.
- A larger deposit (or equity if remortgaging) is required.
Why do I pay more interest with an interest-only mortgage?
The second drawback above is important to consider. The reason more interest is paid on an interest-only mortgage is because the outstanding debt is not being reduced. So interest on the original loan amount is paid every month.
With a capital repayment mortgage, you're chipping away at the capital each month. So over time, as the debt reduces, a decreasing proportion of the monthly repayment goes towards interest and an increasing proportion towards paying the capital.
Can I get an interest-only mortgage on a residential property?
Yes, self-employed applicants can get an interest-only mortgage for residential home purchases and remortgages.
That said, the eligibility criteria for a residential interest-only mortgage are more stringent than they were before the global financial crisis.
You can, of course, get an interest-only mortgage for buy-to-let property investment. The eligibility criteria for getting a mortgage on a residential rental property are less onerous, and typically, only a 25% deposit is needed.
Deposit requirements for owner-occupied interest-only mortgages
You are likely to need a larger deposit than you would for a capital repayment mortgage. Anywhere between 25 and 50 per cent typically, depending on the lender, your circumstances, and the repayment vehicle.
Whilst it's not the norm., one or two mortgage providers will not lend on an interest-only basis unless it can be shown you could afford the equivalent mortgage on a capital repayment basis.