Interest Only Mortgage

An alternative method of mortgage loan repayment is the interest only mortgage. As its name suggests, only interest is paid to the lender on the loan throughout its term, the capital remaining outstanding until the end of the term.

The borrower usually takes out a long term investment to provide the funds required to repay the loan at the end of the mortgage term. Again, life cover to guard against death during the mortgage term is required. The vehicles often used to repay the loan are endowment policies, Individual Savings Accounts (ISAs) or the tax-free cash sum from a personal pension plan.

Since the capital balance of the loan remains unaltered throughout the term (unless, of course, a further advance is effected or a capital repayment has been made), the monthly interest payments remain the same, provided interest rates remain the same, regardless of the term of the loan. The cost of the repayment vehicle may, however, vary with the term.

Summary Points:

•  There is no guarantee that the maturity value of a low cost endowment, the proceeds of an ISA, or the cash sum from a personal pension plan will be sufficient to repay the loan at the end of the term.

•  As the loan progresses, equity in the property builds up solely through the value of the property increasing with the capital due to the lender remaining constant.

•  If the borrower runs into financial difficulty, no options exist to reduce payments to allow the borrower to pay interest only for a time (as they are already paying interest only on the full loan amount). It is also not possible to stop or reduce endowment premiums owing to the qualifying rules. Contributions to an ISA or personal pension plan could be reduced or stopped temporarily, however, this could jeopardise the adequacy of the eventual payout.

•  Interest only mortgages tend to be less flexible concerning changes in term, although this depends on the repayment vehicle. Endowment policies have a fixed term, although many modern policies designed for use with mortgages now include term extension options and sum assured increase options. On moving house, a borrower may be forced to keep to the original term unless these options are available. Alternatively the borrower could keep the original endowment to pay off part of the loan at the original expiry date and effect a new endowment for the additional lending with the extended term. It is rarely in the borrower's best interest to cash in the policy and start again.

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