Interest-only mortgages offer borrowers an alternative way to service and repay a mortgage loan and although these types of mortgages were previously less prominently available, some lenders are offering them again. In this article, we explain what you need to know about interest-only mortgages, how they work, what they cost and what you should consider before opting for one.
What is an interest-only mortgage?
An interest-only mortgage is a loan used to purchase a property in which your monthly payments cover only the interest on the loan, not the loan capital. Paying interest only means that you do not reduce the balance of your mortgage loan through monthly payments. Instead you choose a repayment plan that allows you to repay the mortgage using a lump sum at the end of the mortgage term. The repayment plan will utilise a repayment vehicle which is the specific methods or products for realising the amount of money needed to repay the mortgage loan.
Interest-only mortgages are an alternative to capital and interest mortgages which are usually referred to as repayment mortgages. The monthly payment for a repayment mortgage includes the interest charges as well as capital charges so that you're not only paying the interest but you are also repaying some of the loan money that you borrowed. This method ensures that the full mortgage loan is repaid at the end of the mortgage term simply by continuing to make monthly payments - no lump sum payment is needed.
How does an interest-only mortgage work?
When you borrow money to purchase a property through a mortgage, you will arrange the loan over an agreed 'term', usually between 25 and 40 years. During this time, the mortgage loan accrues interest - the charge that the lender applies for lending you this money. Paying interest only and not reducing your mortgage loan means that the interest accrues on the same amount of mortgage loan throughout the time that you have it.
There are a few things that are helpful to understand when considering an interest-only mortgage. Choosing to pay 'interest only' could make your monthly mortgage payments cheaper, but this will depend on the interest rate you can secure. It is worth noting that the gap in monthly payments between an interest-only and a repayment mortgage narrows significantly when the interest-only option has a much higher rate. Although historically interest-only mortgage interest rates have been relatively high, at the time of writing this article, they are not much higher than those you can get for a repayment mortgage. Another consideration is the effect of choosing to pay 'interest only' on the overall cost of the mortgage, which will be higher due to the fact that the interest accrues against a non-reducing mortgage balance, and we illustrate this in the example below.
How much does an interest-only mortgage cost?
Arranging an interest-only mortgage will require a number of upfront costs as well as the ongoing cost of servicing the mortgage loan. Your upfront mortgage costs may include:
- Deposit payment - the contribution that you make towards the property purchase price, which usually starts at around 15% when it comes to interest-only mortgages and depending on the type of repayment method you choose, the deposit needed may be greater than this.
- Valuation fees - usually these start at around £200 for a basic valuation of the property you wish to purchase
- Legal /Conveyancing fees - solicitors are required to carry out searches, facilitate transactions and ensure that Land Registry reflects ownership changes, and this can cost from around £2,000
- Mortgage broker fees - not all mortgage brokers charge a fee for providing advice and guidance to arrange your mortgage, but where they do, you may expect to pay around £500 for this service (we explain how to get mortgage advice for free later in the article)
- Lender fees - lenders may offer fee-free mortgages but generally, a residential mortgage fee will range between £100 and £2,000.
- Stamp duty - Stamp Duty Land Tax is payable on properties that fall within the parameters set out by HM Treasury and you can find details of how they work in our article “Everything you need to know about Stamp Duty”.
The ongoing costs of your mortgage will include the interest charge that you pay monthly as well as any money that you might contribute to the repayment vehicle. Although the upfront costs for most types of mortgages are similar, it is the ongoing cost that will differ when it comes to an interest-only mortgage. For the comparison below, we have looked at how the regular and overall costs of an interest-only mortgage differ from those for a repayment mortgage. We have assumed that you will borrow a mortgage of £280,000 to purchase a property valued at £350,000 over 25 years, highlighting the differences in the monthly payments, interest charged over the short and long term, and how these factors impact the outstanding mortgage balance below.
Interest-only vs Repayment Cost Comparison
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£280,000 mortgage over 25 years to purchase a property valued at £350,000 |
||
| Interest-only mortgage | Repayment mortgage | |
| Loan-to-value | 80% | 80% |
| Interest rate for a 5-year fixed rate | 3.93% | 3.93% |
| Lender's fee | £1,525 | £1,525 |
| Monthly mortgage payment | £916 | £1,467 |
| Total interest paid over 5 years | £56,544 | £51,619 |
| Mortgage balance after 5 years | £280,000 | £243,591 |
| Total interest paid over 25 years^ | £282,720 | £160,143 |
| Mortgage balance after 25 years | £280,000 | £0 |
^ the total interest paid over 25 years assumes that the rate of interest does not change for the full term - this is unlikely as the interest is fixed for 5 years and will then change
Mortgage interest rates change regularly and you can search the best rates for both interest-only and repayment mortgages using our mortgage rate comparison tool. Ensure you toggle the options to reflect the type of mortgage you would like. Here are some of the best rates for a residential purchase interest-only mortgage at the time of writing this article:
- 2-year fixed rate for an 80% LTV interest-only mortgage at 3.62% interest rate with a lender fee of £1,014
- 2-year fixed rate for a 60% LTV interest-only mortgage at 3.53% interest rate with a lender fee of £1,016
- 5-year fixed rate for a 60% LTV interest-only mortgage at 3.69% interest rate with a lender fee of £1,014
Can I get an interest-only mortgage?
To qualify for an interest-only mortgage, you will need to meet your lender’s qualifying criteria. This will typically include:
- Repayment vehicle - you will need to demonstrate a way to repay the mortgage at the end of the term that fits within your lender's allowable methods. These vary from lender to lender
- Income - a minimum individual income or household income is normally set out by the lender and this may vary depending on the specifics of your mortgage loan and the repayment method you choose
- Loan amount - limits normally apply to how much you can borrow based on your income but you may also find that lenders have overall limits to the maximum amount they will lend under certain circumstances
- Deposit or equity - lenders usually stipulate a minimum deposit for the purchase of a property (or equity in the case of a property you already own but wish to remortgage). These are commonly a percentage of the property’s value
- Loan-to-value (LTV) - this is the percentage of the property’s value that the mortgage loan will cover - remember, interest-only mortgages are generally offered with lower LTV limits.
- Employment status - lenders may not offer an interest-only mortgage to borrowers in certain types of employment, which could include self-employed or contracted employees, as well as those on zero-hour contracts. On the other hand, you may find that some lenders are more inclined to offer a mortgage to a professional at the start of their career, where their income is expected to rise with experience, which may improve their affordability over time
- Credit score - lenders almost always check your credit score and will enforce minimum score requirements for any lending
- Credit history - your payment history and how you manage your finances, as well as any other debts you may have, will be checked when the lender requests your credit report. Late and missed payments, as well as other adverse credit events, could affect the outcome of your mortgage application
These mortgage qualifying criteria are similar for both interest-only and capital repayment mortgages. The additional qualifying criteria you will need to be aware of when it comes to getting an interest-only mortgage pertain to the method of repayment or repayment vehicle you choose, and we explain these here.
How do you fully repay an interest-only mortgage?
Typically, the mortgage loan amount is repaid at the end of the mortgage term using a repayment vehicle that is agreed at the outset. A repayment vehicle is the financial arrangement you establish to repay the loan. Common repayment vehicles include investments, endowments, or a lump sum from your pension, as well as proceeds from the eventual sale of a property. We explain these in more detail below.
Common repayment vehicles for an interest-only mortgage
Sale of mortgaged property
Selling your property to repay the mortgage is usually acceptable as a means of repaying the interest-only mortgage. However, lenders are keen for borrowers not to overestimate the growth in a property's value over time, expecting this to fund downsizing at the end of the mortgage. This type of strategy can be risky if house prices do not achieve the expected growth. Lenders generally set limits around several aspects of arranging this as your repayment vehicle, including a minimum amount of equity in the property as well as a minimum income amount.
Sale of another property
Suppose you own another property and plan to use the proceeds from the sale of this property to repay your interest-only mortgage. In that case, lenders usually won’t consider the full amount of equity you may own in this property towards the interest-only mortgage amount you are applying for. Instead, lenders may limit you to 60% to 80% of the equity value you own at the time of applying for your interest-only mortgage.
Endowment
An endowment policy combines life insurance with a savings element. It's designed to pay out a cash lump sum after a set number of years, or if you pass away during the policy's term, whichever comes first. Part of your payment is invested, often in stocks and shares, with the aim of growing your money over time. However, the final payout amount is not guaranteed and depends on how well these investments perform. Historically, poor investment returns meant some policies didn't grow enough to cover the interest-only mortgages they were linked to. While less common for this purpose now, an endowment policy can still be used as a repayment plan for an interest-only mortgage. It's important to know that when you apply for a mortgage, lenders will treat your monthly endowment payment as a regular financial commitment. This will be factored into their calculations when they assess what you can afford to borrow.
Investment
Shares, unit trusts and investment trusts are potential ways to build funds that can be used to repay your interest-only mortgage. The projected value of these will need to meet the lender’s qualifying criteria and the amount that you regularly invest will be included as part of the assessment of your outgoings to establish whether you can afford the interest-only mortgage.
Pension
You may choose to use the 25% tax-free lump sum from your pension to repay an interest-only mortgage, depending on the fund value of a defined contributions pension or the projected lump sum payment for a defined benefits pension. Your pension contributions will normally count towards your outgoings for affordability checks and the term of your mortgage will likely be limited to run until your anticipated retirement age.
How to select a repayment method for your interest-only mortgage
Lenders vary considerably when it comes to the types of repayment strategies they accept; some accept more ways to repay your mortgage than others. Whichever method you agree to repay the mortgage loan, you will need to demonstrate that it will realistically meet its objective by the end of the mortgage term. Lenders are keen to verify that your planned repayment vehicle meets the target sum required and will typically request evidence that your repayment plan is on track.
Most lenders will accept a combination of repayment vehicles, but this can vary, so you'll need to check the parameters set out for each repayment solution. For example, a lender may limit your mortgage loan to 60% of the property value if you choose to repay it through the sale of the property. Investment-linked repayment vehicles may need to have been in place for a specified period and hold a minimum value from the outset. Most lenders will not allow you to use anticipated inheritance funds to support an interest-only mortgage, and similarly, future bonus payments may not be considered.
This is where it becomes useful to speak with a mortgage broker* as they can help you determine which mortgage option and lender best suits your financial circumstances.
Can I get an interest-only mortgage and switch to a repayment mortgage later?
Yes, some lenders are looking at ways to help people into home ownership through this method whereby a potential borrower can keep their costs low for a short period of time. Lenders that offer this type of mortgage arrangement may require proof of income in the future to ensure you can afford any increase in mortgage payments once you switch to a repayment mortgage. It can be a helpful option for homebuyers who are professionals at the start of their careers.
Can I switch my repayment mortgage to an interest-only mortgage?
Some lenders will allow you to switch your repayment mortgage to interest-only payments. In most cases, this may be allowed to support a borrower with some breathing space if they become unable to afford a mortgage; however, it is quite rare and at the full discretion of the lender. We explain more about making the switch to an interest-only mortgage in our article, "Can I change to an interest-only mortgage? What you need to know".
Can I get an interest-only mortgage in retirement?
Yes, interest-only mortgages are available to borrowers who are retired, however, these 'later-life' lending options tend to be structured slightly differently. You can read more about them in our article "What is a retirement interest-only mortgage and should I get one?".
Alternatives to choosing an interest-only mortgage
Capital and interest / Repayment mortgage
A capital repayment mortgage allows borrowers to repay the mortgage loan through regular payments that include both the repayment of the capital borrowed and the interest that accrues on the loan. It is by far the most popular type of mortgage as it gives borrowers peace of mind that the loan will be repaid at the end of the mortgage term. The interest rates for this type of mortgage are usually more competitive than for an interest-only mortgage, which means the overall cost of the mortgage may be less than you would find when choosing an interest-only mortgage.
Part repayment - part interest-only mortgage
For those who want a bit of both, you can arrange a part and part mortgage, which means that a proportion of the total mortgage is arranged on an interest-only basis and the remainder on a capital and interest basis. This gives borrowers the flexibility to repay part of the loan at the end of the mortgage term while some of it is paid back over the term. It can be a good solution for you if you need a larger loan than a full interest-only mortgage would allow.
Offset mortgage
If you plan to grow your savings with your lender, you can arrange an offset mortgage so that you do not pay interest on the value of your mortgage that is equivalent to the amount of money you hold in a savings or current account. If you choose to arrange an offset mortgage on an interest-only basis, you will need to have a repayment plan alongside, which could include your savings. You can read more about this type of mortgage in our article "Offset mortgages - what are they and who should choose one?".
Pros and cons of interest-only mortgages
Pros
- You could reduce your monthly mortgage payments
- Your repayment vehicle may exceed the expected growth needed to repay your mortgage, providing you with residual funds
Cons
- You may end up paying more interest overall as it accrues against a mortgage balance that stays the same throughout your mortgage term
- There are fewer mortgage products to choose from
- Less competition between lenders, which means your interest rate is likely to be higher
- If your repayment vehicle fails to meet the predicted growth, you may fall short in repaying the mortgage balance
- A shortfall in your repayment vehicle could mean that you do not own your property outright at the end
- A shortfall in your repayment vehicle could mean you have to pay your mortgage for longer than you planned to
How can I get an interest-only mortgage?
Not all lenders offer interest-only mortgages, so you will have to search the market for a lender that offers the mortgage you need. Finding a mortgage that works for you depends on the lender's rules for repayment, as each has its own specific requirements. Mortgage brokers are experts in lenders' qualifying criteria and know how to structure your finances to meet these requirements. Their guidance can be invaluable in securing your mortgage. Additionally, some lenders offer mortgage products that are only available through a broker, so you may find you get access to a greater number of mortgage deals than you could if you were to approach a lender directly.
If you do not have a mortgage broker, you can source one using the online directory of financial professionals, Vouchedfor*,where you can select a mortgage broker based on location, experience and cost. For extra peace of mind, you can see other mortgage customers' reviews before engaging with a mortgage broker. Alternatively, you can contact the online mortgage broker, Habito*, which offers free mortgage advice online and over the phone. The mortgage brokers at Habito are experienced and knowledgeable, and can access over 90 lenders' mortgage deals, providing you with access to hundreds of possible solutions to find the mortgage that best fits your needs.
If a link has an * beside it this means that it is an affiliated link. If you go via the link, Money to the Masses may receive a small fee which helps keep Money to the Masses free to use. The following link can be used if you do not wish to help Money to the Masses or take advantage of any exclusive offers - Habito, Vouchedfor
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