What is an Interest-Only Mortgage?
An interest-only mortgage is a type of mortgage where you only pay the interest charged on the loan each month. This means that you will pay less each month than with a repayment mortgage but at the end of the deal you will still need to pay back the entire amount of the loan.
It may be easier to explain this with an example: Say you borrow £1,200 at (for easy maths) 10% annual interest. The interest would be 10% of £1,200, so £120.
With an interest-only mortgage you’d only pay the £120. Meaning at the end of the year, you’d still owe the £1,200 you originally borrowed. Even though you’ve paid £120, you would still have the same original debt.
This example is an oversimplification but it explains the basic concept of an interest-only loan.
The majority of mortgages are repayment mortgages, this means that you pay off the interest each month plus a percentage of the capital amount, meaning that at the end of your mortgage term you will have paid off the entire debt.
In contrast, interest-only deals solely pay the interest on the mortgage and at the end of the term you will still owe the original amount you borrowed.
Why Choose an Interest-Only Mortgage?
Most people choose an interest-only mortgage because it means monthly mortgage costs will be significantly less than with a repayment mortgage.
Some people also enjoy the flexibility of choosing how to invest their money in order to pay off the balance of the mortgage.
What Are the Ways of Repaying an Interest-Only Mortgage?
The concept behind interest-only mortgages is that you should only go into one if you have an alternative plan to save up the full amount needed to repay the capital loan at the end of the mortgage term.
This is usually achieved through savings, investments or other assets which are termed ‘repayment vehicles’.
It is incumbent upon the mortgage customer to produce a plan to show how they intend to save up enough money to pay off the mortgage at the end of the term. The lender will need to see a credible plan in order to grant the mortgage.
Speculating on property prices or relying on a future inheritance is not generally seen as an adequate plan.
Lenders will want to check that you are on track to save enough to pay off the mortgage at least once during your mortgage term.
Other methods to pay off your interest-only mortgage at the end of the term include:
- Remortgaging – you can take out another mortgage at the end of the term to pay back the original amount. However, you may not be able to get such a favourable deal as you will be older than when you took out the original mortgage.
- Sell the Property – providing the property has maintained or increased its value then you can sell the property to pay off the loan. This method is more popular with people who have buy-to-let properties as it is not their main residence.
What are Suitable Repayment Vehicles for an Interest-only Mortgage?
Some of the most common repayment vehicles for saving enough to pay off your interest-only mortgage include:
- Investing in shares
- Saving money into a savings account or ISA
- Saving your money in a stocks and shares ISA
- Investing in an investment property
The lender will want to see your repayment plan to ensure it is likely to cover the cost of the mortgage. It is sensible to take advice from a mortgage advisor to make sure you will be able to repay the loan at the end of the mortgage term.
Is it Possible to Switch from a Repayment to an Interest-Only Mortgage?
In theory it is possible to switch from a repayment mortgage to an interest-only mortgage by remortgaging or product transfer.
If it is near the beginning of a fixed-rate deal there might be Early Repayment Charges incurred if you want to change your deal.
If you want to temporarily move onto an interest-only deal due to a change in your circumstances, such as experiencing financial difficulties, then speak directly to your lender who will be able to advise you of the right course of action.
What are the Pros and Cons of Interest-only Mortgages?
There are advantages and disadvantages to an interest-only mortgage depending on your circumstances.
Pros:
- Monthly repayments will be smaller than if you have a repayment mortgage.
- Greater flexibility to decide how you would like to invest your money to pay off the mortgage at the end of the term.
- If you are buying to let then an interest-only mortgage can make more financial sense as the monthly payments will be less which will keep your overheads down. The property can then be sold at the end of the mortgage term to pay off the debt.
Cons:
- Risk – You will need to find a reliable way to save up enough money to cover the cost of repaying the mortgage at the end of the term. This makes interest-only mortgages more risky as your chosen repayment vehicle might underperform meaning that you do not have enough to pay off the loan in full.
- Interest-only mortgages work out more expensive overall than repayment mortgages because the amount you owe does not decrease over the mortgage term meaning you pay more interest overall.
- They can be more complicated to manage as the mortgage and repayment vehicle need to be managed separately.
Can you Still Get Interest-Only Mortgages?
Before the 2008 financial crash interest-only deals were quite numerous but after the financial downturn many lenders turned away from interest-only deals, as concerns were raised that these types of deals were allowing people to buy properties which would have been unaffordable under a repayment mortgage.
There were also concerns that people did not fully understand the risks associated with interest-only mortgages and were failing to save enough to pay off the lump sum at the end of the mortgage term.
Since the 2014 Mortgage Market Review by the Financial Conduct Authority lenders have been encouraged to apply more stringent rules on interest-only mortgages leading to a lower take up.
More recently interest-only mortgages have become more popular again, especially for buy-to-let properties. However due to the rigorous requirements that need to be met to secure an interest-only deal it is a good idea to consult with a qualified mortgage advisor to explore all your options.
What is the Criteria for Getting an Interest-Only Mortgage?
The criteria for getting an interest-only mortgage varies from lender to lender so it is important to consult with a mortgage advisor to get the right advice for your personal circumstances.
In general, the criteria for an interest-only mortgage will include stipulations such as:
- Having a good loan-to-value (LTV) ratio (essentially meaning that you have a decent deposit).
- Proving you have a suitable repayment vehicle.
- You might also be asked to prove that you earn sufficient amounts to afford to pay both the interest and the capital loan.
What are Retirement Interest-Only Mortgages?
Retirement interest-only mortgages (RIO) are aimed at older borrowers and work in a similar way to equity release schemes. The borrower only needs to pay off the interest on the mortgage each month but the balance of the loan will be paid off by selling the property when the owner dies or goes into long term care.
For more on equity release schemes read our guide: All you need to know about equity release.
Can you Pay-off an Interest-Only Mortgage Early?
Yes, you can pay off an interest-only mortgage early but as with fixed-rate mortgages this might incur an Early Repayment Charge (ERC) so check with your lender.
Another way to pay off your interest-only mortgage sooner is to overpay on the interest each month thereby reducing the amount outstanding on the loan at the end of the term. Most lenders will allow you to overpay by up to 10% of the outstanding value of the loan each year.
Key Things to Consider When Selecting an Interest-Only Mortgage
Before committing to an interest-only mortgage you need to consider:
- Do you have a reliable repayment vehicle in place to enable you to save enough to cover the entirety of the mortgage loan at the end of the term?
- Do you have a plan in place should your repayment vehicle fail to cover the mortgage at the end of the term?