What is an interest-only mortgage? Are they right for me?

At a glance

• An interest-only mortgage means you only pay back the interest during the mortgage term, and still have the full loan amount to repay on maturity.
• This can result in lower monthly repayments, but also means you need to have a clear plan for repaying the capital.
• If you fail to make your monthly repayments or can’t repay the loan, you could lose your home.

When applying for a mortgage, you’ll typically be presented with repayment deals – but this isn’t the only option. Interest-only mortgages are an alternative and could be worth considering for those who have long-term plans in place, but just what is an interest-only mortgage, and could it be right for you? We take a look.

What is an interest-only mortgage?

An interest-only mortgage is a type of deal that only asks you to repay the interest on the amount you borrowed each month, rather than repaying any of the capital. This means that, at the end of the term, you’ll still need to repay the full mortgage amount, but the idea is that you’ll have a repayment strategy in place in order to achieve that.

Interest-only mortgages are particularly common in the buy-to-let (BTL) sector but they can be an option for residential properties too, although they’re a lot less common here than they used to be. They’re most suitable for those who are confident they’ll be able to repay the full loan amount at the end of the term – such as through a failsafe investment – and who are comfortable with the additional risk of taking on this kind of deal.

How do interest-only mortgages work?

Interest-only mortgages ask you to make set monthly repayments at a pre-agreed interest rate, much like with typical repayment deals. But this is where many of the similarities end.

Instead of gradually paying off your mortgage through those monthly repayments, you’re only paying back the interest charged on it, so at the end of the mortgage term you’ll still owe the initial sum you borrowed – which you’ll be expected to repay in full, usually in a lump sum.

You’ll be expected to have a repayment plan (also known as a repayment vehicle) from the start of the mortgage to ensure you can pay it off at the end.

Examples of repayment vehicles can include:

• ISAs or other savings accounts
• Stock market investments
• Endowment policies
• Pension funds
• Other assets or properties that can be sold
• Inheritance monies or other expected windfalls

Yet there’s no guarantee that you’ll have a big enough pot of money at the end of the term to repay the loan, and if you need to make regular investments, it could have equalled the amount you’d have spent on a repayment mortgage anyway.

You may also be hoping that the value of your property will rise enough over the term of your mortgage to sell it and repay the loan with the proceeds, and ideally have enough left to buy another property. But this can also be a risky strategy given the unpredictability of the property market.

It’s also worth noting that, although the monthly repayments will be lower on this kind of mortgage, the actual amount you’ll pay will be higher by the end of the term. This is because your mortgage balance is never actually reducing, so you’re always paying interest on that full initial amount. This is different to a repayment mortgage, whereby as your mortgage balance reduces, so too will your interest payments, which actually makes it cheaper in the long run.

Calculating interest-only payments

Let’s say you take out a £200,000 mortgage on a 25-year term at an interest rate of 3.5%. On an interest-only deal your monthly repayments would be approximately £583, but over the term of the mortgage, you’d actually pay £375,000 (300 monthly repayments of £583 = £175,000 in interest, plus the original £200,000 loan).

In comparison, if you’d have taken out a repayment mortgage, your monthly repayments would be higher at £1,001, but your total repayment would be far lower at approximately £300,374. This is because your mortgage balance is reducing over the term and so your interest payments will reduce as well, and you also won’t have the £200,000 balloon payment at the end. To get a better idea of the numbers based on your circumstances, use our mortgage repayment calculator.

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

At the end of an interest-only mortgage term you’ll be expected to repay the loan amount in full. This will ideally be achieved through the repayment vehicle you’d initially planned to use, such as maturing endowment policies or ISA funds.

Now’s the time to make any withdrawals necessary in order to repay the lump sum, after which your mortgage will be cleared and you’ll own your home outright. Bear in mind that the lender may check during the term to ensure that the repayment vehicle is still viable, so it’s important to do the same and keep a close eye on your investments to make sure you’re still on track.

What happens if I can’t pay off my interest-only mortgage?

If you’ve reached the end of your term and you can’t repay your loan in full you should speak to your lender. They may be able to offer you another interest-only mortgage or switch you to a repayment deal instead.

Yet if these aren’t a possibility – perhaps your situation has changed and you wouldn’t qualify for a new mortgage – you may have to face the possibility that you could end up losing your home. Always seek help, ideally as early as possible, as there may be things your lender can action before your loan matures.

What are retirement interest-only mortgages?

If you reach retirement and still need to pay off your interest-only mortgage, you may be able to switch to a retirement interest-only mortgage. This product works in much the same way as standard interest-only mortgages, the main differences being that borrowing can be extended past retirement age, and the repayment vehicle will be the sale of your home (usually when you die or move into long-term care).

The other aspects work in much the same way – you’ll only be expected to repay the interest on the mortgage and so monthly payments can be lower, though the full loan amount will still need to be repaid. Because this will usually be from the sale of your home, it means any inheritance you plan to pass on will be reduced.

Can I get an interest-only mortgage?

The criteria for an interest-only mortgage can be a lot tougher than for a typical repayment mortgage. This is because they’re a lot higher risk, and the lender needs to be confident you’ll be able to repay the full loan amount at the end of the term.

As with all mortgage applications, the mortgage provider will take a good look at your income and outgoings and they’ll run a credit check to ensure you can afford your repayments, but be prepared for extra scrutiny. Minimum income requirements can be a lot higher for this type of mortgage, so you stand a better chance of being accepted if you’re a higher earner. Lenders will also want to know how you intend to pay off the outstanding loan at the end of the term, so if you can’t prove this, it’s unlikely you’ll be approved for this kind of deal.

You’ll be expected to put up a bigger deposit for an interest-only mortgage as well, typically at least 20%, but some lenders expect far more. There are fewer lenders who offer these kinds of deals as well, so your choices will be more limited and the rates available likely higher, so it’s even more important to compare mortgage rates thoroughly.

How to get an interest-only mortgage

Your journey to getting an interest-only mortgage will be broadly the same as for a repayment mortgage. Here are the steps you’ll need to take:

1. Gather your documents. Make sure you’ve got everything to hand that you’ll need for your mortgage application. This includes things like bank statements, payslips and in this case evidence of your repayment vehicle. Remember that income requirements will often be stricter, so always check what income you can use for a mortgage application.
2. Check your credit score. You’ll always need a decent credit score to be eligible for the best mortgages, but you’ll likely need an even higher score to get an interest-only deal. Make sure to check your credit score in advance and work on improving it if there are areas that could be better.
3. Get your deposit together. Remember, you’ll probably need a higher deposit for this kind of mortgage, so make sure you can stretch to it. It’s important to check that your goals are realistic as well; use our mortgage calculator to see how much you’ll likely be able to borrow.
4. Apply for a mortgage in principle. Once you’ve got everything in place, it’s time to see if you’ll be approved for a mortgage in principle. There are a lot of things you can do to improve your chances of being accepted, but in this sector speaking to a broker is always advisable. They’ll not only know whether you’re likely to be approved, but they’ll also know the best lenders to approach, and can help ensure that an interest-only mortgage is right for you and your circumstances.