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Interest-only mortgages

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What is an interest-only mortgage?

With an interest-only mortgage, you only pay the interest on the balance of your mortgage each month, so you still owe the whole amount you borrowed at the end of the term. 

This is instead of a repayment mortgage, when you pay off a bit of the capital you borrowed plus the interest each month.

Interest-only mortgages have lower monthly payments than repayment mortgages, but they are riskier as you may find you don’t have enough money to pay off the mortgage when the time comes. They are also more expensive as you pay interest on the whole amount you borrowed over the life of the mortgage.

Buy-to-let mortgages are often interest-only as the landlord can plan to sell the property at the end of the mortgage to repay the amount owed. They're generally much rarer for residential properties.

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How does an interest-only mortgage work?

An interest-only mortgage works by only requiring you to pay the interest each month, which means you have to repay the original amount borrowed at the end of the mortgage term.

Interest-only mortgage repayment plan

It's really important to have a plan for how you will repay the capital you've borrowed at the end of an interest-only mortgage as your lender will ask about this.

You can raise the lump sum required to make the final payment for an interest-only mortgage in several ways. The most common are:

  • Selling your home and using the proceeds of the sale to repay the debt 

  • 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

Both approaches have risks. In the first scenario, you’re counting on house prices rising to pay off your mortgage debt and potentially make a profit. But you could end up owing more than your home is worth if house prices fall, leaving you unable to afford to buy another home.

In the second situation, an investment might not grow enough by the end of the term to give you sufficient funds to pay off your debt.

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What’s the difference between an interest-only and a repayment mortgage?

The main difference is how you pay off the original amount you borrowed, which affects the amount of interest you pay overall.

Interest-only mortgage

With an interest-only mortgage, you pay off just the interest each month, which gives you lower monthly repayments. However, if you’re also paying money into an investment as a repayment vehicle you need to factor this amount into your mortgage costs too. 

As the amount you owe won’t go down during the term, interest is calculated on the whole amount throughout. You won’t have paid any part of the mortgage off at the end of the term.

Repayment mortgage

With a repayment mortgage, your monthly repayments will consist partly of an interest payment and partly of an amount towards the capital you originally borrowed. Over time the proportion that goes towards the interest decreases and the proportion that goes towards the capital increases.

As you’re gradually reducing the amount you owe, interest is calculated on a smaller amount each time. You’ll have paid the whole mortgage off by the end of the term.

Advantages of an interest-only mortgage

Although interest-only mortgages can be risky, there are benefits:

  • Your monthly repayments are lower than with a repayment mortgage

  • You might be able to afford a more expensive property as a result

  • If you’re paying into an investment, it could grow to more than your mortgage debt

  • Interest-only mortgages can be used to purchase buy-to-let properties to keep costs down

Disadvantages of an interest-only mortgage

There are a number of potential downsides to interest-only mortgages:

  • You have to pay off the whole amount you borrowed at the end of the term

  • You could be tempted to buy a property you can’t really afford

  • An investment you’re paying into might not grow enough to pay off the mortgage

  • Selling your home won’t give you enough to pay it off if house prices fall

Fees involved in interest-only mortgages

You’ll pay mortgage set-up fees when you take out the loan. Typically, these include product, valuation and legal fees, although some deals don’t charge them. These fees will be the same whether you take out your mortgage on an interest-only or repayment basis.

The main difference in cost is how much interest you’ll end up paying. For example, let’s say 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% over a 25-year term.

On a repayment basis, your initial monthly repayments will be £788. At the end of the 25 years, you’ll have paid a total of £281,045 including interest of £119,361 and product and valuation fees.

If you took the same mortgage out on an interest-only basis, your initial payments would be £447, and you would end up paying interest of £210,801. Once you add on product and valuation fees and the original loan amount of £160,000, you would end up spending £372,485 in total – more than £90,000 extra.

In reality, though, you would save money on both a repayment and interest-only mortgage if you switch to a new deal at the end of the five-year fixed period rather than paying the lender’s SVR, so would end up paying less over the 25 years.

What happens at the end of an interest-only mortgage?

There are a number of things you can do at the end of an interest-only mortgage to either repay the loan or continue paying it off.

Pay back your outstanding mortgage

If you have the cash available – 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.

If the investment has grown to more than your mortgage debt, you might have even made a profit. 

Switch to a repayment mortgage

You could ask your lender to switch your mortgage to a repayment one if you’re still within your mortgage term. This means you’ll start to pay off the capital as well as the interest.

Bear in mind that your repayments will go up. You may also be able to have a part-repayment and part-interest-only mortgage.

Remortgage

If you’re not in a position to pay off the mortgage at the end of the term you could remortgage your property to a new deal with your current lender or a different one on either a repayment or interest-only basis.

You’ll need to meet the lender’s criteria, though, so there’s no guarantee that this will be possible.

Sell your property

Another option is to sell your property to pay off the mortgage as long as its value hasn’t fallen since you took it out. You’ll still need somewhere to live, so you’ll need to be able to afford to either buy another property or rent.

You might be planning to downsize, though, so will be buying a cheaper property.

Claire Flynn - Senior Mortgages Editor at Uswitch
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If you have an interest-only mortgage, you'll only pay interest over the course of your term, which means you’ll need some 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.”

Claire Flynn

Can I get an interest-only buy-to-let mortgage?

Yes, while few people now use interest-only mortgages to buy their own homes, most buy-to-let mortgages are still interest-only. Borrowing in this way allows landlords to take on more debt without facing crippling monthly repayments. 

As a landlord doesn't live in the property, they can then sell it to pay off the original mortgage debt at the end of the interest-only mortgage term as long as the property hasn’t fallen in value.

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