The Risks of Interest Only Mortgages and How to Avoid Them

| Updated on March 27, 2024

Nowadays, more and more people are looking forward to investing in the real estate market. Whether you are eager to become a first-time owner or want to expand your portfolio, purchasing a house requires significant funding. Fortunately, there are many ways you can borrow money to buy properties. Lenders offer to buy to let mortgages, interest-only mortgages, and even solutions for those with bad credit. Like in every field, there are some risks associated with loans. However, with the right help, you can minimize them and enjoy the life of a proud homeowner.

Also Read: How are Installments Loans Financed?

What is an Interest Only Mortgage?

Interest only mortgages are a type of mortgage where the borrowers only pay the interest on their loan each month. As a result, they don’t have to start paying off the principal until some point in the future. They are often used by people who want to buy a home and need time to save up for a down payment or by those who already own property and are looking for an investment opportunity.

They are more common in countries with high inflation rates because they allow borrowers to take advantage of higher rates of return than they would earn on other investments. Usually, interest only mortgages are an option for those who can pay off their mortgage in five years or less. Additionally, they are also available for those with a low credit score or those who can’t afford to pay off their loan at once.

Also Read: How Much Can You Get From a Reverse Mortgage?

The Pros and Cons of Interest Only Mortgages

Interest only mortgages have been a popular option for many people since they first appeared. In the present day, however, they are still considered a viable solution for borrowing money for various reasons. In most cases, clients will enjoy benefits such as:

  • The chance to step on the property ladder;
  • Lower monthly payments during the term of the loan;
  • More straightforward qualification requirements;
  • Higher borrowing limits and lower taxes;
  • The opportunity to remortgage in the future for purchasing a larger property.

On the other hand, it is worth mentioning that there are many factors you should consider before choosing this type of mortgage. For example, interest-only loans are less popular than other borrowing solutions available on the market. But how to decide whether or not they are the right option for you? You can start by taking into account that you might:

  • Be unable to repay the principal at the end of the term; 
  • Purchase a property that does not appreciate as fast as you projected;
  • Spend more money than you invest.

What are the Associated Risks & How to Avoid Them?

As previously stated, there are some downsides to this type of loan. You should know that the risks are different in each case because they depend on how disciplined the client is. However, you can minimize the risks by understanding how this system works. First, you should not rely on the main characteristic of interest-only loans. While it is tempting only to pay the interest, it would be better also to pay the principal monthly. This way, you will avoid the inability to finish the loan. 

Secondly, some clients end up in the situation of owing more money than they initially borrowed. That happens because they pay too less money each month. When not paying the agreed interest rates at the right time, they will be included in the principal. Therefore, you should respect the dates of each monthly repayment. It is in your best interest to ease the impact of higher repayments that might come otherwise.

Finally, you can face the highest risks at the end of the mortgage. For example, some borrowers experience something called “payment shock”, which is the situation where the debt exceeds their monthly income. Fortunately, you can easily avoid this risk by planning the entire process carefully. More precisely, it would be best if you studied more about the applied interest rates and how an interest only mortgage works. If this type of mortgage is not suitable for you, perhaps you should try other solutions, like buy to let mortgages.

How to Choose the Best Mortgage for You?

Choosing the right mortgage for you can be a confusing process. There are many different types of mortgages out there, and each has its pros and cons. But don’t worry, as there is a solution to step on the property ladder for any person. The key to finding the perfect mortgage is to consider your personal needs. Your income, debt-to-income ratio, and plans for the future are all factors you’ll need to consider when shopping around for a loan. 

So take some time to think about what other debt you have, whether or not you can afford a loan, and how will you be able to repay it. Once you are 100% sure of your plan, it is time to consult a mortgage broker. A mortgage broker is a professional who acts as a go-between for the borrower and the lender. 

A mortgage broker is not a lender. They are not in the business of lending money to people; they are helping people find lenders that fit their needs. A broker works with many different lenders, so they will be able to offer you various options. They can help you decide which mortgage product is best for your needs, and they can help you get approved.

Who Needs Buy to Let Mortgages?

Recently, the number of landlords has gradually increased due to the ease of purchasing properties and renting them out. Another reason includes the relatively low cost of borrowing money. Buy to let mortgages are designed for holders who own a single property or a small portfolio of properties they rent out to tenants. They are not intended for first-time buyers and exist primarily to provide an opportunity for those already on the property ladder to diversify their investment by buying additional properties.

Buyers may also purchase a buy-to-let property, renovate it, and then resell it for a higher price. Therefore, this type of loan might be better for some people than an interest only mortgage. However, no matter which one you choose, it is essential to constantly check the real estate market because housing prices can fall or rise at any moment.

Buying to let is becoming increasingly popular due to many reasons. The main benefit of buy to let mortgages is that they provide many opportunities to advance on the property ladder. Moreover, you can use the income from renting to keep up with the monthly payments. Ultimately, applying for a mortgage in a time of need can be greatly helpful. What’s important is to check with the broker to understand the terms of the contract thoroughly. When it comes to finances, you should always be well-prepared.

John M. Flood

John is a crypto enthusiast, Fintech writer, and stock trader. His writings provide guides to perform your best in the crypto world and stock planet. He is a B-Tech graduate from Stanford University and also holds a certification in creative writing. John also has 5 years of experience in exploring and understanding better about the FinTech industry. Over time, he gained experience and expertise by implementing his customized strategies to play in the crypto market.

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