An interest only mortgage offers a cheaper way to purchase a property, than with a standard capital repayment mortgage. The catch is that you are only actually paying off the interest accrued on the loan amount, meaning that at the end of the mortgage term, you still have to pay off the original loaned amount for the value of the property.
This worked great prior to the financial crash, as the rapid rise in property prices allowed owners to recoup their costs, and in many circumstances actually earn additional money from their investment. The clear risk with this was, should property prices fall, then it's likely that you'd find yourself in 'negative equity'- as the price of your property would now be worth less than the original amount borrowed; thus leaving you with a financial deficit.
Endowment Policies and Clearing the Original Debt
Previously, interest only mortgages had been sold alongside endowment policies, which were designed to pay off the remainder of the debt alongside the interest only loan. This was considered a low cost way of buying a home- combined with the benefits of a long-term investment. Basically, endowment policies were investment funds; a way of investing and saving simultaneously. Providers would promise that the policy would clear off your mortgage debt as well as providing a lump sum amount at the end, earned from profit they had made from using your money for investing elsewhere.
As you can probably imagine, a lot of these investment funds underperformed and homeowners were left with debts they thought they had covered. The result was pretty much the demise of endowment policies, but it is still possible to use investment vehicles such as an ISA or other high interest fund to work alongside an interest only loan. Lenders are more wary now about using risk-based investments, but with a reasonable 'plan' put forward for repayment, it's still possible to take this route if it's suitable for you.
Can 'Interest Only' work for me?
In certain circumstances, taking out an interest only mortgage can still work in your favour. This is particularly apparent in London, and other expensive south-east areas, where you might struggle to secure a capital repayment mortgage. Although you'll only be paying off the interest, you will still own your own property and it's often cheaper than renting.
In such areas there seems little chance of the prices falling at the moment, but you should be aware of the risk of ending up in negative equity. Regardless, you should look to switch to a capital mortgage as and when you’re able to, in order to save some cash and get it all paid off quicker. If you don't, your property will be technically owned by the lender; with you effectively paying 'rent' to live there
Interest only mortgages are also popular amongst buy-to-let landlords, as they can claim tax back against the interest of the mortgage. But regardless of your personal intentions, legislation has now been tightened as there is a concern that interest only mortgages are being increasingly taken out by people who are likely to struggle with financial difficulties. As a result you'll need to face a number of probing questions from lenders, regarding your financial situation, as well as intended contingency plans you might have, should interest rates rise. And submit a credible plan for repayment of the original loan debt alongside that of the interest only loan.