What Happens at the End of an Interest-Only Mortgage?

Interest-only mortgages can be a useful financial tool for certain types of borrower, but they also come with a critical phase at the end of the term when the full repayment of the loan becomes due. In this article, we will explore what happens at the end of an interest-only mortgage, and the risks and benefits involved in managing this type of mortgage.  

Understanding Interest-Only Mortgages

An interest-only mortgage allows borrowers to pay only the interest on the loan until the end of the mortgage term, which is typically 25 – 30 years’ long from the outset. This means that the monthly mortgage payments are significantly lower than they would be under a traditional repayment mortgage, as none of the principal, i.e. the original amount borrowed, is being paid off over the course of the mortgage term.

This structure can be beneficial for borrowers looking to reduce their monthly outgoings in the short term, such as investors in buy-to-let properties. However, it does mean that at the end of the interest-only period, the entire loan principal remains outstanding, creating a significant financial obligation.

Reaching the End of the Interest-Only Term

When the interest-only term comes to an end, borrowers are faced with the requirement to pay off the entire loan principal. This situation can cause considerable financial stress if not planned for adequately. There are several potential outcomes for borrowers at this stage, and they largely depend on the preparation and financial strategy employed throughout the mortgage period.

1. Repaying the Full Loan Principal
   Ideally, borrowers will have been saving or investing during the interest-only term to build up a lump sum to pay off the full mortgage balance. This could be through a dedicated savings plan, such as a stocks and shares ISA or a pension lump sum withdrawal. Some borrowers also use inheritance, bonuses or the sale of assets to repay the loan. If the borrower has been disciplined in building up these funds, they can clear the loan in full, thus owning their property outright and no longer having to make any further mortgage payments.

2. Refinancing the Mortgage
   If the borrower is unable to repay the full amount at the end of the term, they may be able to remortgage to extend the mortgage term. However, remortgaging is not guaranteed. The borrower’s eligibility will depend on their age and credit score, and the current value of the property and the lender’s affordability criteria.

3. Switching to a Repayment Mortgage
   Some lenders may allow borrowers to switch to a repayment mortgage before the interest-only term ends. In this case, the borrower would start paying both the interest and the principal, but over a much shorter remaining term, which would lead to significantly higher monthly payments. This could be challenging if the borrower’s income is insufficient to handle the larger payments.

4. Selling the Property
   If none of the above options are feasible, selling the property might be necessary to repay the mortgage. This is a common strategy for buy-to-let investors who intend to sell the property at the end of the mortgage term. Technically, there is the risk that, due to adverse property market conditions, the proceeds from the sale of the property are not sufficient to repay the mortgage. In this situation, the borrower will have a personal liability to pay off the shortfall.

Risks and Challenges of Interest-Only Mortgages

The primary risk of an interest-only mortgage is the potential difficulty in repaying the principal at the end of the term. While the monthly payments are lower during the interest-only period, borrowers face a large financial burden when the mortgage ends. Several challenges can arise during this phase:

• Insufficient Savings or Investments
  Many borrowers rely on long term investments or savings to accumulate enough funds to repay the loan. However, if these investments underperform, they could fall short of the required amount. For example, stock market fluctuations or low interest rates on savings could result in a shortfall, leaving borrowers scrambling to find other sources of funds.

• Refinancing Challenges
  Refinancing an interest-only mortgage may not always be possible. Lenders consider a borrower’s age and assess their ability to repay based on their financial situation, including their credit score, the loan-to-value ratio and affordability. If, for example, the borrower has reached the age of 70 or the borrower’s financial situation has deteriorated or if house prices have fallen, meaningful refinancing may become difficult or impossible.

• Property Market Risk
  If a borrower is relying on selling their home to repay the mortgage, the state of the housing market at the end of the mortgage term can pose a risk. A downturn in property prices could mean the sale of the property does not cover the full loan amount, leaving the borrower with a remaining debt to settle.

Managing the End of an Interest-Only Mortgage

The key to successfully navigating the end of an interest-only mortgage is early planning and preparation. Here are a few steps borrowers can consider to manage the situation:

1. Create a Repayment Strategy Early On
   From the beginning of the mortgage term, borrowers should have a clear plan for how they will repay the loan principal. This might include regular contributions to a savings account, investments or pension schemes. It is crucial to review and adjust this plan as necessary over the years to ensure it remains on track.

2. Regularly Review Finances
   Borrowers should regularly assess their financial situation to ensure they are still on course to repay the loan. Changes in circumstances, such as income changes, new financial obligations and property market conditions, can impact the original plan. Staying on top of these factors can help borrowers make informed decisions well in advance of the end of the mortgage term.

3. Explore Remortgaging Options Early
   If refinancing is part of the repayment plan, borrowers should explore remortgaging options a few years before the end of the interest-only period. Securing a new mortgage deal early can provide peace of mind and avoid a last minute scramble to arrange financing.

4. Consider Selling
   Homeowners who plan to sell their property to repay the loan should be prepared to do so early, if necessary. By planning for this outcome in advance, borrowers can minimise stress and ensure they have the funds needed to settle the mortgage.

Conclusion

Interest-only mortgages can provide flexibility and lower monthly payments, but they come with the responsibility of repaying the entire loan principal at the end of the term. Without proper planning, borrowers can face significant financial challenges. However, with a well planned repayment strategy, regular financial reviews and exploring refinancing or property sale options, borrowers can successfully manage the end of an interest-only mortgage and move forward with their financial goals.

By understanding the risks and taking early action, investors can ensure that they are prepared for the eventual repayment and avoid undue financial strain when the time comes.

FAQs:

Q. What is an interest-only mortgage?
A. An interest-only mortgage is a type of mortgage where the borrower only pays the interest on the loan during the mortgage term. During this period, the loan principal remains unchanged. However, borrowers are required to pay back the full principal at the end of the mortgage term.

Q. What happens when my interest-only mortgage term ends?
A. At the end of the interest-only period, the full loan principal becomes due.  

Q. Can I switch from an interest-only mortgage to a repayment mortgage?
A. Most lenders will allow borrowers to switch from an interest-only to a repayment mortgage. This option can be taken before the end of the interest-only period, but it will result in higher monthly payments, as you will start repaying both interest and the principal.

Q. How can I repay the loan principal at the end of an interest-only mortgage?
A. Borrowers usually prepare to repay the loan principal by saving or investing during the interest-only term. Common methods include building up a savings account, investing in a stocks and shares ISA, selling the property, or using a lump sum from a pension or inheritance.

Q. What are the risks of an interest-only mortgage?
A. The main risk of an interest-only mortgage is the need to repay the entire loan principal at the end of the term. If a borrower has not saved enough, cannot refinance or faces a drop in property values, they may struggle to repay the mortgage, potentially leading to the sale of their property and further personal financial strain.

Q. Can I remortgage after an interest-only term ends?
A. Remortgaging is a possibility for those who cannot pay off the principal at the end of an interest-only mortgage term. However, remortgaging depends on factors such as age, credit rating, the property’s value and affordability, and approval is not guaranteed by any means.

Sources:

Interest Only Mortgages | FCA

What if I can’t repay my Interest Only Mortgage? | Legal and General | Published Jan 2024