Interest-Only Mortgages

With an interest only mortgage you make monthly repayments for an agreed period but this will only cover the interest on your loan.

As the name suggests, with an interest only mortgage your monthly payment only covers the interest charges on your loan - you're not actually reducing the loan itself. You'll normally also have to pay into another investment or savings plan that'll hopefully pay off the loan at the end of the term.

In this section, we look at the pros and cons of taking out an interest-only mortgage, and look at some of the ways you might choose to back your plan up.

Pros and Cons

Interest-only mortgages are more risky than repayment mortgages, as there is no guarantee that you will pay off the loan and so own your home when the mortgage comes to an end. This is because, instead of paying back the loan little by little, the whole of your monthly mortgage payment is made up of interest. None of the capital you have borrowed is paid back into the end of the mortgage term, when you will be expected to pay off the entire loan in one go.

To ensure that you have a sufficiently large lump sum to be able to do this, you should make payments into some kind of savings plan to back up your mortgage, as well as making the normal mortgage payments. The risk you take is that the savings plan may not produce the lump sum you need to repay the mortgage, although if your investments do exceptionally well you could end up with more than you need to clear your mortgage debt.

Disadvantages

• Your debt remains constant throughout the mortgage period.
• There is no guarantee that you will have sufficient funds to pay off the mortgage at the end of the repayment period, as the investment could perform below that assumed at the start.
• Some forms of investment may incur a penalty fee if you stop paying premiums.

Advantages

• Because you're only paying off the interest, and not the loan itself, your monthly payments will be lower.
• You can choose an 'investment vehicle' that is tax efficient.
• If the investment growth rate exceeds those estimated at the outset, you may be able to pay off your mortgage early or receive a lump sum at the end of the repayment period, in addition to paying off your mortgage.

Backing Up and Interest-Only Mortgage

If you are attracted by the idea of combining the purchase of a property with the discipline of regular, long-term saving, you need to decide on the kind of savings plan you are going to use to back up your mortgage. Lenders make it very clear that it is YOUR responsibility to make sure you are saving enough to build up the lump sum you will need to repay the loan. If you fail to keep up the payments into the savings plan, or don't pay into a savings plan at all, when the mortgage comes to an end the lender can make you sell your property if that is the only way you have of raising the cash needed to repay the full amount of the loan.

There are a number of ways that you can choose to back your mortgage up, including the following:

With an ISA

The attraction of the mortgage backed by an individual savings account (ISA) is that an ISA is a more flexible and tax-efficient way of building up the lump sum and an endowment, and it doesn't have to include life insurance. The main disadvantage is that your investments are tied into the stock market, so there is still no guarantee that you will build up the lump sum you need. You also need to be prepared to keep an eye on how will your investments are performing.

With an Endowment

In the past, the most popular form of savings plan to back an interest-only mortgage was an endowment policy. This is essentially a life-insurance policy linked to stock market investments. The main disadvantages of this kind of savings plan that includes life insurance you may not need and you are tied to paying the monthly premiums for the full term of the mortgage. If you don't, you risk getting back less than you paid in.

Even if you do manage to keep up the monthly premiums, there is no guarantee that your savings will grow sufficiently to produce the necessary lump sum. In recent years, thousands of people have been told that their policies are not on track to repay their mortgages because the underlying stock market investments have not performed as well as had been expected. This endowment scandal has prompted most lenders to give up recommending interest-only mortgages backed by an endowment, in favour by ISA-backed mortgages.

With a Personal Pension

Using a personal pension to back an interest-only mortgage is tax-efficient, but also very risky. The idea is that you pay into a personal pension (which includes stakeholder pensions) with the aim of building up a fund that will be used both to pay you a pension and pay off your mortgage. However, only 25% of this money can be used to pay off the mortgage, so the fund built up in the pension plan is to be at least 4 times the size of your mortgage.

You should also be aware that if you have more than 25 years to go before retiring, you have to play mortgage interest for longer than your would with a mortgage linked to another sort of investment - you will be paying until you decide to take your pension.