Interest-only mortgages

What is an interest-only mortgage?

With an interest-only mortgage, all you pay each month is the interest on the amount you borrowed. You don’t have to pay the full amount back until the mortgage term has ended. This differs from a repayment mortgage, where you pay back both interest and some of the loan each month, which steadily reduces the debt until it’s fully paid off by the end of the mortgage term.

Why would you have an interest-only mortgage?

Interest-only mortgages aren’t for everyone, but they may be an option if you have a clear plan to save enough for the eventual repayment, such as a relatively safe investment policy, or a promise of future income or a windfall, and if you are totally aware of the risks that come with it.

How do interest-only mortgage loans work?

You’ll pay interest on a monthly basis during the mortgage term, which might be as short as a few years or more than 20 years. Once your mortgage term is over, you’ll still owe the lender the same amount you initially borrowed – so you’ll need to either pay it back or remortgage your home. Before lenders give you an interest-only mortgage, they may need to see evidence of your ability to pay off the full amount at the end of the term. This is called a ‘repayment vehicle’ – it might be something like an investment, endowment policy, or ISA.

What are the benefits of interest-only mortgages?

Some people like the flexibility to be able to make lower payments initially, and pay more when their income or savings increase near the end of their mortgage term.

  • Your monthly payments are much lower than with a repayment mortgage, as you’re only paying the interest on your loan
  • If the investments you make work well, you may be able to pay the loan back quicker than with a repayment mortgage – and without having to sell or remortgage
  • If you know you’ll come into enough money to cover the full cost of a home, a repayment mortgage may not suit you. But if you won’t receive the money for a number of years, an interest-only mortgage can help you buy property now, and still pay off the purchase price in one go once the mortgage term ends

What are the disadvantages of interest-only mortgages?

The biggest disadvantage is the pressure of knowing that you have to ensure the loan is repaid in full at the end of the interest-only mortgage term.

  • You’ll usually pay more interest overall than with a repayment mortgage, because the amount you pay interest on doesn’t decrease during the term
  • You’re only paying off interest each month, so you’ll still owe full the full amount at the end of the term
  • You have to look after your repayment vehicle as well as a mortgage
  • If your repayment vehicle relies on investments, pension funds, an inheritance or a rise in house prices, it may not make enough to pay off your mortgage

As with repayment mortgages, if you’re on a fixed rate and you want to pay off your interest-only mortgage early you may be charged early repayments fees – check the terms of your mortgage for details about this.

How do you calculate interest-only payments?

For example, if you borrow £100,000 over a 25-year period, at a fixed rate of 3.5%, an interest-only mortgage would allow for a considerably cheaper monthly payment than a repayment mortgage.

However, as the table shows, you’ll pay less in total with a repayment mortgage. This is because interest is charged as a percentage of the total amount you owe – and with a repayment mortgage, this amount decreases over the term as you pay it back. With an interest-only mortgage, the amount you owe stays the same.

 
Monthly payment Total amount paid over 25 years
Interest-Only
£292 £187,579
(£87,579 interest plus £100,000 loan capital outstanding)
Repayment
£501 £150,238
(£100,000 loan capital fully paid off plus £50,238 interest)

With an interest-only mortgage, at the end of the mortgage term the full £100,000 loan is still owed - whereas with a repayment mortgage, the full amount has been paid off.

What should I do before applying?

Here are some key things to consider before you apply for an interest-only mortgage:

Compare mortgages

Think carefully about your alternatives to an interest-only mortgage. It’s important to understand the different types of mortgages available, and how they may fit your present and future needs. Make sure to compare mortgage offers from different providers too, to help you find the best deal –remember to read the terms of each offer carefully.

Check what you can afford

Lenders need to be confident that you can afford your monthly mortgage payments, even if interest rates go up or your circumstances change. They may take into account not only how much you’re earning, but also how much you’re spending.

Improve your credit score

Lenders may look at information on your credit report – along with details from your application form, and from their own records (if you’ve been a customer before) – to calculate your credit score. This helps them decide whether to give you a mortgage. A good credit score suggests you’re lower risk and a reliable borrower, so lenders are more likely to approve you. There may be several steps you can take to improve your credit score. You can get a good idea of how lenders may view you by checking your free Experian Credit Score.

Your repayment plan

It’s likely that lenders will want you to have a suitable plan in place to pay off the loan once the interest-only mortgage term is over. Think about how you’ll afford the repayment, the risks involved, and how to give the lender evidence of your plans. You may want to consult a mortgage broker on this – they can give you expert mortgage advice, although some charge a fee.

What do I do once I get an interest-only mortgage?

Here are our suggested steps for when you’ve got an interest-only mortgage:

Manage your repayment vehicles

It’s sensible to review your repayment vehicle regularly, to ensure your plan for repaying the loan is on track. If you’re relying on investments, you may need to actively manage the risks. If your plan is to save, ensure your budget is still realistic and that you’re sticking to your goals. If anything goes wrong with your repayment vehicle, and you’re concerned you won’t be able to repay the loan at the end of the term, speak to your lender to discuss your options.

Manage your payments well

Making your monthly interest payments on time and in full is crucial. Late payments could mean getting charged penalty fees, getting a default or CCJ, or even losing your home. You could consider setting up a direct debit so you never forget to make a payment.

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