Methods of Repaying an Interest-Only Mortgage

Methods of Repaying an Interest-Only Mortgage

When you take out an interest-only mortgage, your monthly mortgage payments only cover the interest accruing on the amount you have borrowed. The mortgage balance – also known as the “capital” – doesn’t reduce over the term of the mortgage, and this means that at the end of the agreed mortgage term you will have to repay the amount still outstanding at this time. There are various types of plans and investments that can be used to pay off an interest-only mortgage, and these are sometimes collectively referred to as “repayment vehicles”.

Types of repayment vehicles

There are a variety of savings and investment plans that are commonly used to repay an interest-only mortgage, but be aware that some lenders may not accept certain types of plans (for example, cash savings) – from a lending point of view, the lender needs to have an assurance that you can afford the mortgage and will be able to pay off the debt at the end of the mortgage term. Examples of repayment vehicles include

  • Stock and shares ISAs
  • Investment bonds
  • Shares
  • Unit trusts
  • Pension schemes
  • Endowment policies (but see below)
  • Cash savings, for example a cash ISA
  • Other properties or owned assets

It’s important to remember that most types of investments can fluctuate and change in value over time – stock prices can go down as well as up and, indeed, the past few years have shown that even house price appreciation can not be depended upon as a constant. That’s why it is vital to periodically check your repayment vehicle over the years to ensure it is on track to pay out the expected value by the time your interest-only mortgage term comes to an end.

What if I don’t have a repayment vehicle, or if I have a shortfall?

Today lenders require evidence that a suitable repayment vehicle is in place as part of the application process for interest-only mortgages, however, in the past this wasn’t always properly checked. The result, according to a recent report by the Centre for Economics and Business Research, is that one in ten people with a current interest-only mortgage have no plan in place to repay the debt – meaning that they could potentially default on the mortgage loan and have their homes repossessed.

Going back some years, endowment policies were the preferred choice of repayment vehicle for interest-only mortgages, and many borrowers took out this type of policy in the 1980s and early 1990s. Unfortunately, many endowment plans – and some other types of investments – subsequently failed to perform as well as expected, leaving homeowners with a projected shortfall in the plan’s maturity value compared to the original mortgage borrowed.

If you have no repayment vehicle in place, or if you know there will be a shortfall in the amount that is due to pay out, then you need to act sooner rather than later. There may be various options open to you, including converting either all or a portion of your interest-only mortgage to a repayment basis (either with your existing lender or by remortgaging to a new lender), making overpayments (or lump sum part repayments) to your mortgage to reduce the balance, and taking out a new savings or investment plan that will plug the gap. For people over 55, it may also be possible to resolve the situation by utilising an equity release scheme, such as a lifetime mortgage or home reversion plan.