Updated 03 September 2020
An interest-only mortgage is a type of mortgage where your monthly repayments only repay the interest on your loan, not the loan itself. This means that the loan itself isn’t repaid over time, but will still need to be repaid in full by the end of the mortgage term or sooner.
Find out more about interest-only mortgages and why you might want one.
If you take out an interest-only mortgage, you’ll still be charged monthly payments by your lender. These payment will be smaller than the monthly cost of a repayment mortgages.
However, these payments won’t reduce the size of the loan – they’ll just pay off the interest as it accrues, so the loan sum won’t grow any bigger. So for example, if you borrow £100,000 on a 20-year interest-only mortgage, at the end of that 20 years you’ll still owe £100,000.
When your interest-only mortgage term comes to an end, you will need to repay the loan somehow – either by selling the property, using savings, or taking out another mortgage (remortgaging).
Your monthly payment on an interest-only mortgage is quite simple to work out, as it’s just the interest on the total sum.
For example, if you borrow £200,000 on a 3 per cent mortgage, your annual interest will be £6,000 – so your monthly payment is £6,000 divided by 12, or £500.
Over 20 years this will mean you pay £119,900 in monthly payments, and you’ll also have to repay the £200,000 – making a grand total of £319,900.
By contrast, with a repayment mortgage you also pay off some of the capital sum with each monthly payment. The same loan as a repayment mortgage would cost you £1,100 per month, and at the end of 20 years you’d have repaid a total of £266,170.
When the term of your interest only mortgage comes to an end, you will face a bill for the amount of the original loan. You will need to have a plan in place for how you will pay this.
There are several ways you might repay an interest-only mortgage:
You can repay an interest-only mortgage simply by taking out another mortgage (which could be repayment or another interest-only one). However, you’ll need to make sure you still meet a lender’s criteria – you’ll be older by this time, and your circumstances may have changed.
You can of course sell a property to repay an interest-only mortgage. This is more common among those who buy to let. If you are lucky, the property price will cover the whole loan amount with some left over – but if you are unlucky and run into negative equity, you may have to cover a shortfall.
If you have accumulated enough money in the form of other investments, you could use these to pay off your interest-only mortgage. This was the principle behind the ‘endowment mortgage’, but these products became obsolete when many homeowners found that their investments could not generate enough returns to repay their mortgage loan.
If you can’t repay your interest-only mortgage by other means, the property that you’ve bought with it will have to be sold. If the sale of the property is not enough to cover the loan (i.e. it is in negative equity) then your other assets may be at risk.
Here are the advantages and disadvantages of an interest only mortgage.
The main benefit of an interest-only mortgage is that your monthly payments will be cheaper. This means that you could potentially borrow more.
If you are buying your own home, an interest-only mortgage may help you to afford a more costly property than you otherwise could – provided you can commit to switching to a repayment mortgage as soon as you can.
If you are buying to let, an interest only mortgage can be more convenient, as it keeps your overheads lower, and when the term expires you can just sell the property to repay the loan.
The biggest drawback of an interest only mortgage is that you don’t pay off the loan as you go. This means you have to find another way to do this – you can’t just forget about it!
Another downside of interest-only is that the total amount you repay over time will be greater.
Finally, it is harder to find interest-only mortgage deals, especially if you’re a first-time buyer. You are likely to need a much bigger deposit and a higher income – which may well cancel out any advantage that comes from cheaper repayments.
The most popular use of the interest-only mortgage is to buy to let. Sometimes people in retirement take out interest-only mortgages that will be repaid from the sale of their homes when they die.
Here are some more commonly asked questions about interest only mortgages.
You can move your interest-only mortgage to a repayment one, either by remortgaging or by product transfer. It’s worth talking to a mortgage broker about this to make sure you find the best value deal when you switch.
If you are concerned about being able to repay your mortgage, you may be able to extend the term. Talk to your lender as soon as possible about this.
If you’re currently on interest-only and can’t yet afford to switch to a full repayment mortgage, you can usually switch to a hybrid mortgage where part of it is repayment. You’ll still need a means to pay off the interest-only portion, though.
Most landlords prefer interest-only mortgages, as it keeps their overheads low. The loan can eventually be repaid by selling the property (hopefully at a profit) so provided you can afford the initial deposit, interest-only is often your best bet.
Talk to a mortgage broker if you’re trying to decide between repayment and interest-only mortgages. Find out about mortgage broker fees.
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