Talk to me like I’m 5. Interest only - why? And how?

[Tusktusk]

I understand what interest only is. What I don’t get is how do people repay the loan at the end of the term? And why take this kind of mortgage?

Asking because I’m looking at buy to let mortgages and interest only seems to be the majority of products available.

Don't do it.

Speaking as someone who once had one - DON'T DO IT.

What you are supposed to do is take out an endowment insurance policy which matures on the date when the mortgage needs to be paid off (or if you die before then). So you pay the interest on the loan amount, plus insurance premiums.

The policy sum paid out at the end of the term is supposed to equal the amount you owe on your mortgage. A large number of people who took out these policies in the 1980's found that their investment had not grown anywhere near enough to pay off their mortgages.

A friend who’s dad is a property investor has only ever had these kind of mortgages, and was shocked when we had a repayment one.
If you own 6 flats it makes total sense, because at the end of the term you just remortgage, or sell a flat. You will probably get back more than you put in, because of property growth, and you can use the months to buy more flats. Especially in the days when you could offset the interest against the tax.
It’s not so great if you only have one property, because the risk isn’t spread. And it’s a stupid idea for your residential property because you need to live somewhere if you have to sell.

The monthly payments are lower so that's the 'why'.

I know a couple of people who used them to buy their first flats about 20 years ago when they were in their early 20s. Allowed them to get on property ladder and after a couple of years when their salaries increased they changed to repayment mortgages.

I also know someone who had 2 buy to lets on interest only. She sold them when her mortgage term ended - and made quite a lot of money as they had more than doubled in value. She had no option but to sell as she wasn't in a financial position to be offered a new mortgage and didn't have the money to pay off the original loans.

You used to have to prove that you had a repayment plan in place, like an endowment. Now endowments didn’t do what they promised and providers are still offering them.

The idea is, you only pay the interest on the loan, but have another plan to pay the capital off. Hopefully inflation erodes the bulk of the capital. So if you bought a house 30 years ago for £100k, that sum is so much less now the capital repayment should be easy. In reality it hasn’t worked out like that for a lot of people. And they are left looking at downsizing or other plans

For a residential property you need a repayment vehicle - a pension, endowment or other policy for example. I doubt you’d find a lender prepared to lend a residential mortgage on an IO basis without such a vehicle.

BTL is different though. You may not want or need to acquire equity for tax or inheritance reasons, you won’t get to 80 and find yourself still having to work to repay the interest to keep your home, if you need the capital you either sell or remortgage.

Alot of buy to let mortgages are on this basis as repayments are lower, rental income will easily cover the payments. As it is a buy to let property nearing the end of mortgage term sell the property and repay the borrowing.

Ours wil be repaid via final salary scheme this November.
But there are various ways - you can downsize for example from 4 bed to a flat.
You can (in era of 1% interest rates take the cash you'd repay monthly loan with with and invest in stock market (only if you know what you are doing). Even at conservative 5% returns you are making money.
Inheritance is another.
They can be useful IF you have strategy to repay.

Inflation or downsizing can often sort most of the issue out. So if you want a bigger house whilst you have kids then you van do interest only and just sell and downsize once they have left. It is also just a minimum so you can over pay if you want to. We tend to save up and reduce the mortgage when we remortgage every 2 or 3 years.

In theory, as property prices go up, your mortgage balance balance stays the same. At the end of the term you have to have had accumulated the cash somehow.
This is a very good idea in certain situations: i) your property is an investment and selling if you have to, is not an problem; ii) you are older and could use it as a form of estate planning or if you don’t give a beep about leaving any inheritance and just want to burn your money while still alive; or iii) you have the largest part of your pay as variable payments, so it’s easier to manage your cash flow.

Im sure there are other situations-but definitely not for everyone!

I’m on the scenario 3! but I could only get a 50% LTV. I am hoping to change it to interest only when it’s time to remortgage in 5 years.

Yep, it used to the model as generally the property will increase in value, could be sold and it was better tax-wise. You can't get interest-only on residential properties now like you could before the financial crash.

Things are very different now. You're taxed on turnover, not profit so most investors are using a company structure to buy property as the taxation is different.

It works if you have more than one property. We have multiple properties and we don't intend to pay the mortgages on all of them off so interest only is fine. You need a strategy to have at least one fully paid off mortgage before you retire, how you do that really doesn't matter.

Micawberism

They hope that something will turn up one day to pay off the debt.

Maybe it will.