What is an interest-only mortgage?
An interest-only mortgage is a type of loan that allows you to pay back only the monthly interest charged on your borrowing. Your monthly payments don’t reduce the loan, so the size of your debt remains the same for the duration of the mortgage term, and must be repaid in full at the end of the term using a repayment vehicle such as savings, investments or other assets.
How do interest-only mortgages work?
As you are not paying off the capital until the end of the term, your monthly payments are lower than they would be with a repayment mortgage. You will need to build up a lump sum of money in order to pay off the amount originally borrowed at the end of the term, and a lender will ask you to provide evidence of how you intend to do this.
Once your mortgage term ends your lender will expect you to have a sufficient lump sum to repay the loan. If you do not, and cannot afford to switch the mortgage to a repayment basis you may be forced to sell the property to pay back the debt.
In the past it was common for borrowers to take an endowment policy to repay their interest-only mortgage, however, due to poorer-than-expected investment performance, many borrowers found their endowment policies did not provide enough to repay the outstanding debt. This meant that many people had to extend their mortgage term and keep paying long after they expected it to be repaid.
Repaying your interest-only mortgage
Before you apply for an interest-only mortgage, you must have a clear idea of how you’ll repay the capital you’ve borrowed.
Lenders will only agree to offer you an interest-only mortgage if you can demonstrate that you have a repayment vehicle in place. Acceptable repayment plans vary from lender to lender, but options could include ISAs, pensions, investment bonds and regular savings plans.
Your lender will usually check that your repayment plan is on track to pay off your mortgage at the end of its term.
It’s essential that you also regularly review your plans to repay your mortgage, and take action if you don’t think you will have sufficient funds to clear the loan at the end of the mortgage term.
What is the difference between interest-only and repayment mortgages?
When you take out a repayment mortgage, each month you repay some of the capital you’ve borrowed, along with some interest.
By the end of your mortgage term, you will have repaid the whole loan and all the interest.
With an interest-only mortgage, as the name suggests, you only repay the interest you owe each month, and not any of the original sum you’ve borrowed, which means your monthly payments will be lower. However, when the mortgage term finishes, you’ll need to repay the amount you originally borrowed.
Who can get an interest-only mortgage?
Interest-only mortgages are available for both residential and Buy to Let properties, although lending criteria are typically less stringent for Buy to Let properties as a landlord will be treating the property as an investment rather than their home.
In both cases homebuyers will need to have a substantial deposit, typically at least 75% of the property value, to put down. For residential properties, a lender could require as much as 50%, and they may also have minimum income requirements.
Homebuyers and landlords must be able to demonstrate that they have a capital repayment strategy in place before lenders will agree to offer a mortgage on an interest-only basis.
What are interest-only mortgages for landlords?
Buy to Let mortgages are usually arranged on an interest-only basis so that landlords can keep borrowing costs to a minimum and rental income can cover monthly payments.
At the end of the mortgage term, the capital must be repaid using the proceeds of a savings or investment plan, or the landlord may decide to sell their property to pay off what they owe.
Find out more about whether you should choose an interest-only or repayment Buy to Let mortgage here.
What are Retirement Interest-Only (RIO) mortgages?
Retirement Interest-Only mortgages are designed for older homeowners who are approaching retirement, or are already retired and are looking for a mortgage.
They are designed to enable homeowners to carry on paying their monthly mortgage interest payments until they die or go into long term care. At this point, the property is sold and the capital is repaid to the lender.
In order to qualify for a Retirement Interest-Only mortgage, you must be able to demonstrate that your retirement income can cover the monthly payment,
You can find out more about Retirement Interest-Only mortgages here.
What are the advantages of an interest-only mortgage?
The main benefit of an interest-only mortgage is that your monthly payments will be lower than with a repayment mortgage as you’re only paying back the interest and not the capital you owe.
As there is less to pay back each month, it should be easier to stay on top of your repayments.
Interest-only mortgages also offer flexibility, with most lenders enabling borrowers to make overpayments if they’re able to.
What are the disadvantages of an interest-only mortgage?
The biggest disadvantage of an interest-only mortgage is that you aren’t paying back any of the capital you owe, so you’ll need to have a repayment plan in place to do this at the end of the mortgage term.
The performance of investments can go up and down over time, so there are often no guarantees that any repayment plan you do choose will produce enough to pay off what you owe.
You can switch to a repayment mortgage if you’re not confident that you’ll have enough to clear your mortgage at the end of the term, but if you can’t afford to do this because the monthly payments will be too expensive, you may have to sell your property.
Is an interest-only mortgage right for you?
If you are considering an interest-only mortgage, you must have a suitable way to clear the capital owed at the end of the term. This may include investment policies, such as ISA’s or pension lump sums, sale of other assets such as second properties or in some cases downsizing.
If you have an endowment mortgage and are concerned about your policy falling short you can use our endowment shortfall calculator to work out the costs involved in changing some of your interest-only mortgage onto a repayment basis.
What to do if you can’t repay your interest-only mortgage
If you’re worried about not being able to pay off your interest-only mortgage at the end of your mortgage term, the good news is that there are other options available.
Switch to a repayment mortgage
Switching your mortgage from interest-only to repayment will mean that your monthly payments increase, but your mortgage will be repaid in full at the end of the term.
If the payments are likely to be too high, you could consider switching to a part-interest, part-repayment deal.
Alternatively, you could take a full repayment mortgage but extend the mortgage term in order to make the monthly repayments more affordable.
Another useful way of reducing your debt is to make lump sum payments or regular monthly overpayments. This method gives you the flexibility to pay off additional capital as and when you can afford it. You will need to check the terms of your mortgage deal however to find out if there are any restrictions.
Many deals only allow you to pay off an additional 10% of your balance per year for example.
Extend your interest-only mortgage term
You may be able to extend your interest-only mortgage term to give you more time to cover the debt, however, this may not be possible if you plan to retire soon.
You can talk through your mortgage options by speaking to our fee free mortgage advisers who will help you choose the most suitable mortgage for your situation.
They can advise which types of deal might be suitable if switching to an alternative mortgage is the best option for you, and support you throughout the mortgage application process.