With an interest-only mortgage, you only repay the interest charged on your loan each month, rather than repaying any of the actual loan itself. This means at the end of the mortgage term, you'll still owe the total amount you borrowed when you took out the mortgage.
Because you’re not repaying any of the capital (amount borrowed), interest-only mortgages have lower monthly payments than capital repayment mortgages. However, in the long term you'll pay more interest, as it's charged on the full loan amount each month, for the whole mortgage term.
This is unlike a repayment mortgage, where the amount you've borrowed will reduce over time until you own the property outright. Your interest payments will also reduce as the balance gets smaller.
Interest-only mortgages are most often used for Buy-to-let properties, and it's quite rare to use one to buy a residential home. Some lenders offer them for this purpose, but they are usually only offered to higher-income earners with a large deposit.
When you take out an interest-only mortgage, your lender will need to know how you plan to repay the capital at the end of the mortgage term. They may refer to this as your repayment plan or repayment vehicle.
Lenders each have their own accepted repayment plans. Some are more cautious than others, but the most common ways are:
Selling the property
An investment product, such as an endowment, pension or ISA
Saving some of your rental income (if it’s a buy-to-let)
Selling another property or asset you own
Some lenders may be happy with a combination of the above
The major risk with this type of mortgage is that you may find your chosen repayment method doesn't raise enough to pay off the mortgage capital at the end of the term.
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The below table shows a direct comparison between interest-only and capital repayment mortgages:
|Interest-only mortgage||Repayment mortgage|
|You pay off just the interest each month||You pay off both the interest and a chunk of the capital (loan amount) each month|
|Lower monthly repayments (although consider that you may also need to pay into a repayment vehicle)||Higher monthly repayments|
|Interest is charged on the entire loan throughout the full term of the mortgage||Your interest charges reduce over time as you repay the loan. Interest is due on a slightly smaller balance each month|
|At the end of the mortgage term you will still owe the full loan amount||At the end of the mortgage you will have fully repaid the loan and own the property outright|
Interest-only mortgage rates are typically higher than they would be on a repayment mortgage, as there is more risk to the lender. You will also pay more interest over the duration of the mortgage, as it's charged on the full amount you borrowed for the whole term (typically 25 - 30 years).
For example, if you borrowed £160,000 to buy a £200,000 home at a fixed-rate of 3.35% for five years, followed by a standard variable rate (SVR) of 5.75% for the next 20 years, over a 25-year term:
With a repayment mortgage
You would repay a total of £281,045
The interest paid over the full 25 year term would be £119,361
You monthly repayments would be £788
With an interest-only mortgage
You would repay a total of £372,485
The interest paid over the full 25 year term would be £210,801
You monthly repayments would be £447
So, as you can see, in the short term, your monthly repayments are £341 more affordable, but you will have paid more than £90,000 in extra interest charges overall by the time you have repaid the mortgage.
Please note: The above are illustrative examples to show the difference between interest-only and repayment deals - in reality you're likely to remortgage to a new deal at the end of your five-year fixed deal, to avoid going on to your lender's SVR, which is typically higher.
It really depends on what you want one for. If you’re looking for a buy-to-let property, then this would be considered the typical route and the vast majority of lenders will be happy to offer an interest-only mortgage for your investment purchase.
If you’re looking for an interest-only residential mortgage it will be much more difficult, as there are fewer lenders willing to offer interest-only mortgages for this purpose. Those that do have fairly strict criteria, such as:
A larger deposit
Usually higher minimum income requirements - £50,000 - £75,000 for single applicants and £100,000 for joint applicants typical minimum thresholds
Often a lower LTV (loan to value) than if you used a repayment mortgage
First-time buyers are likely to struggle to get a residential interest-only mortgage, but it could be more achievable for those looking for an interest-only remortgage. This is because if you have a good amount of equity in your property, it can be used as a deposit and/or to lower the LTV of your borrowing.
There are specific interest-only products aimed at older borrowers, known as a retirement interest-only mortgage (RIO). These are often a cheaper alternative to equity release for retired individuals.
This will depend on the lender, but generally, you will need a larger deposit for an interest-only mortgage than for a repayment mortgage.
Most lenders are likely to want a deposit of at least 25%, but some may ask for 40% or more. This is because they are taking more risk with an interest-only mortgage, as they are less certain that your repayment method will cover the full cost of the loan.
As with other mortgages, the best interest-only mortgage rates will be reserved for those able to offer the greatest deposit.
At the end of an interest-only mortgage term you'll need to repay the outstanding lump sum of the loan - the full amount that you originally borrowed. Your lender will have approved your repayment plan already and will likely check-in with you throughout the mortgage term, to ensure you're on track to afford it.
However, maintaining the repayment vehicle is your responsibility, so it’s a good idea to monitor the progress of this at least annually. This could be regularly checking up on your relevant savings and investments or keeping an eye on local property prices to ensure your home’s value has increased (if you plan to resell it).
Each lender will make it clear which repayment methods are acceptable to them when you make your mortgage application. Usually you will have a choice of options, and this could include any of the following:
If you have the cash available – perhaps from savings or an inheritance, for example – or the investment you used as a repayment vehicle has grown enough to pay off the mortgage, you can pay back the loan in full.
If you don’t have the cash available or the value of your repayment vehicle hasn’t grown as much as needed, you could ask your lender to switch your mortgage to a repayment mortgage or remortgage to another lender onto a repayment mortgage.
Bear in mind that depending on your age, the repayment term you are offered at this point could be shorter than 25 years, so the affordability criteria for the monthly repayments may be fairly high. You would also be paying interest twice on the same property.
Another option is to sell your property to pay off the mortgage, so long as its value hasn’t fallen since you took it out. The likelihood is that it will have gained value over that length of time, however, so you may be able to downsize to a smaller home using some of the proceeds of the sale as a deposit - or to buy it outright if your profit is big enough.
If you’re able to repay some of the loan, but you can’t cover the whole amount, it may be possible to extend the term, however the lender will need to see evidence that the extension will provide you enough opportunity to repay the outstanding balance.
If your chosen repayment method leaves you unable to repay the mortgage, and you are not able to qualify for a remortgage or extension, you will have no choice but to sell your home. If the sale of your property is then unable to cover the full loan figure, your other assets may also be at risk, as the lender will need to recoup their losses.
If you’re in the later stages of an interest-only mortgage term and have concerns that your repayment plan will not completely cover the lump sum repayment, it may be possible to remortgage onto a repayment mortgage, or part and part mortgage (part interest-only, part repayment). This way you can to try and reduce the loan balance before it becomes payable.
If you're over 55, you could also consider a retirement interest-only mortgage, which has no fixed end date. Therefore you won't have to repay the loan balance until you pass away or move into long-term care, at which point the lender will sell your home and keep enough of the proceeds to cover what you owe. This will reduce the value of your estate, however, so keep that in mind if you were planning to leave the proceeds of your home sale for inheritance purposes.
Your monthly repayments are lower than with a repayment mortgage
You might be able to afford a more expensive property
If you’re paying into an investment, it could grow to more than your mortgage debt allowing you to repay your mortgage and make a profit
Useful when investing in buy-to-let properties to keep business costs down
You still owe the whole amount you borrowed at the end of the term
An investment you’re paying into might not grow enough to pay off the mortgage
Selling your home may not give you enough to repay the loan if house prices fall
You will pay more interest over the mortgage term than with a repayment mortgage
Lenders require a larger deposit (usually 25% or more)
There's a higher risk of negative equity than a repayment mortgage as you will not gain any equity from repaying the loan, and rely entirely on a rise in property prices
If you have an interest-only mortgage, you'll only pay interest over the course of your term, which means you’ll need to pay back the amount you borrowed at the end. They tend to be far more common for buy-to-let properties as you can sell the property at the end of the term to repay the loan.”
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