Interest Only Home Equity Loan – Complete Overview
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Interest-only home equity loans do exist through mortgage products. If you want to use some of your home equity and only pay back the interest rate of the loan and none of the principal, then you should read this guide.
We clarify the situation and answer some of the most important questions when considering an interest-only home equity loan/mortgage.
Understanding home equity
Home equity is defined as the amount of your home you actually own without attached debt, usually expressed as a percentage based on the current property value. You can calculate the amount of equity in your home by taking away the outstanding balance of your mortgage from the property’s value (not the price you paid for it).
It’s much easier to understand with a simple example. Let’s imagine you have a property currently worth £175,000 and a remaining mortgage of £100,000. Your home equity can be calculated by subtracting £100,000 from £175,000, equaling £75,000.
This means your home equity would be £75,000, and as a percentage, it’s just below 43% of the property (£75,000 / £175,000 x 100). Home equity can increase as you make monthly payments on your mortgage. But it can also increase or decrease based on changes to the property’s value, due to property market changes, gentrification and renovations.
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What is a home equity loan and home equity line of credit?
A home equity loan and home equity line of credit (HELOC) are two ways of using the equity you have to access credit.
They will enable homeowners to access a loan amount equivalent to up to 80-85% of their property equity. If you have £100,000 equity you might be able to get a loan or HELOC as large as £85,000. Both options use the money you have in your home as security, and if you do not stick to the repayment terms, the lender can force you to sell the property to repay.
You should only apply for either with a lender that is authorised and regulated by the Financial Conduct Authority (FCA).
Do you pay interest on a home equity loan?
You have to pay interest on a home equity loan or a home equity line of credit. However, the interest rates are not usually the same and the way the interest is repaid differs between both credit options.
We’ve explained more just below.
How do home equity loans and HELOCs work?
Home equity loans provide a lump sum amount that is repaid with a fixed rate of interest straight away. The full loan will be repaid over an agreed long-term period, sometimes as long as 20+ years.
On the other hand. A home equity line of credit provides a line of credit that can be used by the homeowner(s) as needed over a set timeframe called the draw period. During the draw period, only variable interest payments are required, and once the draw period ends, the homeowner(s) must start to pay back the loan and interest.
HELOCs aren’t interest-only forever!
Because you only have to pay the variable rate of interest on a HELOC during the draw period, some people categorise them as interest-only home equity loans – but they are not.
A HELOC is not an interest-only home equity loan because you have to repay the principal at a later stage. They’re only interest-only for an initial period of a few years.
Can you get interest-only home equity loans?
There are credit options that let you borrow based on your home equity and only require interest-only repayments. Sometimes they are called interest-only home equity loans, but that’s not a 100% correct name for them.
What is an interest-only home equity loan?
An interest-only home equity loan is a loan that gives you a loan amount based on your home equity (and uses it as collateral). But instead of making payments to repay the loan value and the interest, the homeowner only needs to pay the interest through monthly payments and never any of the principal.
Interest-only home equity loans are officially called interest-only mortgages (when used to release equity). We’ve explained how a specific type of interest-only mortgage works to release equity just below.
How do interest-only mortgages work?
Interest-only mortgages only require the individual to pay back the interest on the mortgage rather than the actual loan borrowed. However, at the end of the mortgage, the full mortgage balance will still be owed. The benefit of an interest-only mortgage is that monthly payments are significantly lower.
Some people put the money they save into investments to repay what is owed at the end for cheaper (IF those investments are profitable during the course of the mortgage).
These types of mortgages soared just after the financial crisis of 2008 when people struggled to get mortgages. However, many lenders were providing these mortgages without ensuring the homeowners would be able to repay the capital at the end of the mortgage and struggled to repay. It has now become more difficult to get a standard interest-only mortgage.
Can you release equity on an interest-only mortgage?
Interest-only mortgages are not just used to buy property. They can be used to release equity as well, providing you have home equity available in the first place. One way of achieving this is through a specialist mortgage for seniors called a retirement interest-only mortgage.
What is a retirement interest-only mortgage?
A retirement interest-only (RIO) mortgage works in the same way as a general interest-only mortgage with two major differences.
The mortgage can be used to release a lump sum of equity on a property you own outright, rather than to buy a home. And instead of having to pay the principal amount of the loan at the end, you don’t have to. Rather, you continue making monthly interest payments until you either die or sell the home to enter a care home for the elderly.
The principal amount of the loan – i.e. the equity you release – is only repaid from your estate when the lender sells the property.
Eligibility for a retirement interest-only mortgage
To be eligible for a retirement interest-only mortgage, you must own a home in the UK, and the home you want to release equity from should be your main residence.
Although some sources will tell you that a retirement interest-only mortgage is only available for people over 55, there is no actual age restriction. However, most lenders will only provide this equity release option to people over 55, and more certain if you are in your 60s.
For borrowers to be approved, they will need to prove to the lender that they can afford the interest repayment each month.
How much equity do you need for an interest-only mortgage?
To get a retirement interest-only mortgage, you generally need to own the full home outright with no outstanding lien of credit. In other words, you must have 100% equity in the home. If you have some debt attached to the property, it might make it difficult for the lender to recover the funds from a property sale after you die.
The pros and cons of a retirement interest-only mortgage
You should seek professional advice before considering any equity release option or new mortgage. Here are the pros and cons to start you off:
- A wide range of lenders offer these mortgages at competitive rates
- No restrictions on what the money is used for (retirement, holidays, renovations helping family etc.)
- Your inheritance will be less affected compared to similar products, such as a lifetime mortgage (see below)
- You can continue living in your home as long as you stick to the repayment terms
- You can lose your home if you do not pay the interest payments
- Your family will receive less inheritance
- Equity release is usually based on personal finances, which will more likely be retirement income rather than previous employment income
What’s the difference between a lifetime mortgage and an interest-only mortgage?
A lifetime mortgage is another product that can be used to release equity for retirement. It is also known as a reverse mortgage, but this term is more commonly used in Canada, the USA and Australia.
Lifetime mortgages allow the homeowner to access home equity as a lump sum or ongoing monthly payments. The funds are only paid back upon death from the homeowner’s estate (possibly through the property being sold), or if the property is sold before death to go into aged care.
If there are two homeowners, which is common for married or de facto couples, then the principal and interest will only be repaid when the surviving partner dies.
They can be identical to an RIO mortgage where the homeowner makes interest payments over time and therefore makes it another type of interest-only home equity loan.
The benefit of this is that it increases any remaining inheritance to beneficiaries. Otherwise, the homeowner can choose to make no monthly payment at all and allow the interest to roll up and be paid from the estate. This is the main difference between a lifetime mortgage and a retirement interest-only mortgage.
To get approved for a lifetime mortgage you will need to check off eligibility criteria similar to the RIO mortgage. However, applicants will still need to have their personal financial situation assessed, including their credit score.
Should I use an interest-only home equity loan?
The decision to use an interest-only home equity loan to release equity is an entirely personal decision, which will also be determined by eligibility and subject of approval.
Many families choose to sit down with family and explain the situation, especially with those who are likely to be beneficiaries of the homeowner’s will. Using the service of a finance or mortgage professional first is highly recommended and sometimes mandatory.
More mortgage and equity loans help!
More free information and FAQs are being answered on new MoneyNerd home equity loan guides. Homeowners are free to search our website and learn more about these equity release options without the confusing jargon.