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An interest only mortgage may offer cheaper monthly repayments, but there is a catch. Make sure you're not caught out by understanding how an interest only mortgage works with our guide.
There are two main ways of paying off your mortgage: repayment and interest only. With a repayment mortgage, you pay an amount towards the original sum borrowed, plus interest. With an interest only mortgage, you only pay the interest on the balance of your mortgage each month - so the amount you are borrowing remains the same.
Interest only mortgages are the cheaper option for monthly payments, but they are also riskier and can end up being more expensive than repayment mortgages in the long term.
Interest only mortgages allow you to pay lower monthly repayments. However, as you are not paying back your mortgage debt you are, in effect, renting your home from your lender. It will only be yours when you repay the original amount borrowed at the end of the mortgage term. You can find the lump sum required to make this final payment in several ways. The most common are:
By selling your home and using the proceeds of the sale to repay the debt
By using a ‘repayment vehicle’ - an investment or savings account that matures alongside the mortgage to cover the amount you owe by the end of the term
Let’s say you borrowed £160,000 to buy a £200,000 home, at a 3.7% APR and over a 25 year term.
The annual interest on this is £5,920, so this will be how much you will have to pay to the lender each year on an interest-only mortgage. On a repayment mortgage, you would pay this amount as well as monthly repayments towards your mortgage debt.
Monthly payments would be around £493, meaning the total you would pay over 25 years is £148,180 (plus the original £160,000). Over the lifetime of the mortgage, it will therefore cost you £308,180.
Your monthly payments would be £818, meaning over 25 years you would pay £245,479.
In these circumstances, an interest only mortgage would cost you over £60,000 more - £62,701 to be exact - over the full term. If you were unable to raise the cash to pay off the original debt, you would also have to sell your home.
Interest only mortgages are quite rare today. To get one, you will also have to convince the lender that you have a credible plan, such as an ISA or other investment fund, for repaying the debt at the end of the term.
This is not just to protect the lender. It’s also a Financial Conduct Authority (FCA) requirement designed to protect you from losing your home once your interest only mortgage is paid off. Your income and spending will also be very strictly assessed to determine whether you can afford the mortgage, including whether or not you could cope if interest rates rise.
While few people now use interest only mortgages to buy their own homes, many buy-to-let mortgages are still interest only. Borrowing in this way allows landlords to take on more debt without facing crippling monthly repayments.
Lenders take the potential rental income into account when determining mortgage affordability for buy to let mortgages, which are not regulated by the FCA in the same way as residential mortgages. And as landlords don’t live in the properties, they can then sell them to pay off the original mortgage debt at the end of the interest only mortgage term.
Some people also use interest only mortgages to buy second homes, while others take out an interest only mortgage to avoid paying very high rents. It’s one way to get on to the property ladder, although it is advisable to switch to a repayment mortgage as soon as possible to pay back debt.
A riskier option to take is to gamble on house prices rising. You could sell, pay off your mortgage debt and potentially make a profit. However, should house prices fall though you could end up owing more than your home is worth.
Using any form of risk-based investment - be this the value of your property, or other investments - to buy your home requires careful consideration, as you could easily end up with insufficient funds to pay off your debt at the end of your interest only mortgage term.
Last update: 27 January 2021
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