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A Guide to Interest-Only Mortgages

No impact on credit score

Pete Mugleston

Author: Pete Mugleston - Mortgage Advisor, MD

Updated: August 26, 2021

If you’re looking to buy a property, you may have considered the possibility of an interest-only mortgage. We are approached all the time about interest only loans from UK borrowers as they have additional criteria and factors to consider, and can be harder / more complex to arrange than a traditional repayment mortgage.

To help you understand this concept in more depth, this article is going to explain what an interest only mortgage is, as well as a whole host of other things.

What is an interest-only mortgage?

An interest-only mortgage is a type of mortgage agreement where the borrower is only obligated to pay off the interest each month. Capital repayments are usually optional, but the debt itself would normally only be repaid after the end of the term via a pre-agreed repayment vehicle.

How do they work?

If you take out an interest only mortgage, you borrow money for a property but only repay the interest owed to your lender each month. You do not pay off any of the capital that you owe until the end of the mortgage term. Paying back interest only on a mortgage can be a tempting prospect as the monthly payments are considerably lower than the “usual” repayment mortgages, which can make them appear more affordable for buyers.

This, however, can be deceptive; as you’re not paying back anything you borrow, you are then required to repay the total capital owed at the end of the mortgage term. What’s more, you must also provide your lender with substantial proof that you are able to afford these repayments at the end of the period. We’ll discuss this in more detail later on.

Repayment mortgages vs interest-only mortgages

Interest only mortgages differ from repayment mortgages in the sense that, with repayment mortgages you gradually repay the money you’ve borrowed on the full mortgage amount throughout the agreed term. With repayment mortgages you make one payment a month to your lender, part of which goes towards repayment of the actual loan, and the rest covers the interest. This means your monthly payments are higher than that of an interest-only. For in-depth information about how interest-only mortgages compare to repayment mortgages, check out our dedicated article on the topic.

How are interest-only mortgages different?

When it comes to interest only mortgages, you’re only paying the mortgage interest to your lender, so your monthly payments can be  far lower than a repayment mortgage. However, this means you will need to make other arrangements for paying back the full capital. This is referred to as setting up a “repayment vehicle”, which can either mean paying a separate monthly sum into another investment, or using another asset / investment that already has a value that would cover the loan. You will also need solid proof of a legitimate repayment vehicle in place to pay off the capital of your mortgage later on.

Acceptable repayment plans vary by lender, and may include (but not limited to)…

  • Savings in ISAs
  • Stock market investments
  • The sale of a property
  • Remortgaging

Your lender is also likely to make required checks that your chosen repayment plan is on track to pay the required amount. Interest only lending was very popular a decade or so ago, when many buyers were able to borrow on an interest-only basis without showing lenders proof of how their debts would be repaid. However, it later emerged that a huge number of interest-only customers were struggling to pay off their loan at the end of their term, a massive problem which has led to tighter regulation and requirements.

Comparison table

Interest-only Mortgage Repayment mortgage
Minimum LTV required 15% (individual circumstances and other factors may affect this) 5% (individual circumstances and other factors may affect this)
Repayment per month Interest charged by mortgage provider Interest charged by mortgage provider, plus part of the mortgage loan
How much owed at end of mortgage term Full value originally loaned by mortgage provider Nothing
What is the monthly interest based on? Current balance, which without any other repayments, is the full amount originally loaned from mortgage provider Remaining amount you owe on your mortgage (will decrease each month)
Associated risks Must have money available to repay mortgage at the end of the term Home is in danger of being repossessed if monthly repayments are not made Not meeting monthly repayments in full could result in repossession
What else do you need to know? Potential to make a profit due to freedom to invest money that would otherwise be spent on monthly capital repayments. Potential for more interest to be paid in the long run as interest is due on the full value of the loan for the duration of the mortgage. Equity will grow with each monthly repayment. The greater your equity, the better rates you’ll be able to access in future.

Deposit requirements

Nowadays it is a lot more challenging to borrow on an interest-only basis; far fewer lenders are willing to offer this type of loan (therefore limiting your choice and access to the most competitive rates), and those that do will have strict criteria, typically in the form of a high deposit. Most lenders require at least 25% deposit, max lending to 75% loan to value (LTV). Some can consider up to 80% LTV, and a handful 85%

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Advantages and disadvantages

Provided you have a sound repayment plan in place however, there are advantages to taking out an interest-only mortgage, and they include…

Lower monthly payments

As you are only paying back the interest on your loan your monthly payments will be far lower than with a repayment mortgage. For example, if you borrow £200,000 interest-only over 25 years at an interest rate of 3%, you’d pay £500 a month. If you were to repay the mortgage on a repayment basis you’d be set back £948 a month. But bear in mind that, while this approach makes a mortgage more affordable in the short term, in this scenario it would mean that after the 25 years were up you’d still owe the lender £200,000.

Control over investments

You have the ability to decide how you repay the capital of your mortgage after the period is up. For example, you could put the money you save into home improvements (thus increasing the value of the property), alongside setting some away into a savings plan each month.

Potential to profit

If you invest in a sound repayment vehicle, you may be left with a lump sum that not only covers your mortgage repayments, but gives you some extra cash to play with. This could be used towards increasing your mortgage payments (therefore allowing you to pay off the capital and gain more equity in the property faster), or put towards home improvements or other means as you see fit.

Potential drawbacks

There are also considerable disadvantages to consider, regardless of whether or not you have a stable repayment vehicle in place:

Added expense

With interest-only schemes you can end up paying more interest in the long run, as you are charged interest on the full sum borrowed for the duration of the term.

Payment is inevitable

Payment must be made after the interest-only term ends. Even though you’ll benefit from the perks of smaller monthly payments initially, you need to have a good plan in place as to how you’re going to repay the capital, otherwise you risk losing your home.

Interest-only mortgage rates

Interest only mortgage rates don’t tend to be drastically different to typical repayment mortgage rates – provided there is strong evidence that you are able to repay the capital, and of course taking individual circumstances into account.

It’s also useful to note that, due to the associated risk with this type of mortgage there are fewer lenders offering to lend, especially at higher Loan to value (LTV), therefore you may be more limited in your options and less likely to be offered the most competitive rates on the market.

But that doesn’t mean finding a deal with favourable rates is impossible. If you’ve decided this product might be for you, get in touch and the advisors we work with will compare interest-only mortgages across the entire market to help you find the lender offering the best deals for somebody in your circumstances.

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

If you’re concerned that you aren’t going to be able to pay off the capital owed at the end of the period, you should take action as soon as possible – even if you’re years away from the end date.

There are several options available to you, including:

  • Asking for an extension
  • Downsizing
  • Selling another property
  • Using a pension, savings or other investments
  • Remortgaging
  • Switching to a repayment plan
  • Equity release

Find out more in our guide outlining what happens at the end of an interest-only mortgage term.

Interest-only buy-to-let mortgages

While interest only mortgages are not generally recommended for first time buyers, they are usually the go-to option for buy to let landlords. Most lenders are happy to accept BTLs on an interest-only basis (other factors taken into consideration). This is because it is assumed that the property will be sold to repay the mortgage at the end of the term – although this of course relies on the housing market being resilient so the house is worth the same or more than what it was at the time of purchase.

See our complete guide to buy-to-let mortgages for more information.

Interest-only lifetime mortgages

Another way an interest-only mortgage can be beneficial is if you already own your home outright, or own a considerable amount of equity in the property. For individuals over the age of 55, you may be eligible to take out an interest only lifetime mortgage. This is a cost-effective form of equity release which is essentially a long-term loan secured on a property that you either fully or partially own.

This scheme allows you to withdraw a lump sum of cash from the equity you own, which you can spend on whatever you please. Interest is charged on the amount you’ve borrowed, which can be paid off, or more commonly, added onto the total loan amount.

See our guide to interest-only lifetime mortgages for more information.

Getting an interest-only mortgage with bad credit

Having certain types of credit issues can limit the number of providers willing to lend to you, so as a result the rates available can be higher. That said, approval mainly depends on the type of issue, and when it was registered, and it’s possible to get approved on interest only mortgages with late payments, defaults, CCJs, mortgage arrears, debt management plans, IVAs, repossessions and bankruptcy.

Thankfully there are specialist lenders out there who cater for borrowers with credit issues, and the advisors we work with work with them on a daily basis. See our guide to bad credit mortgages for more information.

Speak to an interest only mortgage expert

If you’re considering an interest-only mortgage, the way to begin is by taking professional advice from a mortgage broker who specialises in this type of borrowing.

A broker with the right knowledge and experience can offer you bespoke advice on interest-only mortgages, guide you through the application process and make sure you get the best deal available. We offer a free-broker matching service that can pair you up with the ideal mortgage advisor, based on a quick assessment of your needs and circumstances.

Call 0808 189 2301 or make an enquiry and we’ll set up a free, no-obligation chat between you and a broker who specialises in interest-only mortgages today.

FAQs

What is an interest-only mortgage payment holiday?

A mortgage payment holiday is an agreement you can make with your lender which allows you to temporarily stop or reduce your monthly repayments. When your payment holiday ends you have to start repaying again. After which time the payments usually increase to make up for the missed months’ and extra interest owed. Not every lender offers this, so check the T&Cs of your terms.

Can I get tax relief on an interest only mortgage?

Previously, Buy to Let investors would only have to pay income tax on their net rental income, having deducted any interest and allowable expenses throughout the year. From April 2020 this will no longer be possible.Can I get an interest only mortgage with cash?

Can I get an interest only mortgage with cash?

Lenders are very unlikely to accept cash for any type of deposit unless there is proof that it comes from a legitimate source and can in no way be associated with money laundering. Neither is cash acceptable as a legitimate repayment vehicle in which to pay off the capital at the end of an interest only mortgage term.

Can I refinance an interest-only remortgage?

Yes, of course. As long as you meet the lender’s eligibility and affordability requirements, you should be able to refinance onto another interest-only product. You can read more on this in our guide to interest-only remortgages.

Can I extend my interest-only mortgage term?

Yes. This is something interest-only mortgage customers often fall back on if the end of the term is approaching and their repayment vehicle is unlikely to pay out enough. Extending the term can buy you more time, but whether it’s agreed is at the discretion of your lender.

It could also be possible to remortgage onto a longer agreement with another mortgage provider, but again, the length of the mortgage agreement is at their discretion.

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About the author

Pete, an expert in all things mortgages, cut his teeth right in the middle of the credit crunch. With plenty of people needing help and few mortgage providers lending, Pete found great success in going the extra mile to find mortgages for people whom many others considered lost causes. The experience he gained, coupled with his love of helping people reach their goals, led him to establish Online Mortgage Advisor, with one clear vision – to help as many customers as possible get the right advice, regardless of need or background.

Pete’s presence in the industry as the ‘go-to’ for specialist finance continues to grow, and he is regularly cited in and writes for both local and national press, as well as trade publications, with a regular column in Mortgage Introducer and being the exclusive mortgage expert for LOVEMoney. Pete also writes for OMA of course!

Read more about Pete

Pete Mugleston

Mortgage Advisor, MD

FCA disclaimer

*Based on our research, the content contained in this article is accurate as of the most recent time of writing. Lender criteria and policies change regularly so speak to one of the advisors we work with to confirm the most accurate up to date information. The information on the site is not tailored advice to each individual reader, and as such does not constitute financial advice. All advisors working with us are fully qualified to provide mortgage advice and work only for firms who are authorised and regulated by the Financial Conduct Authority. They will offer any advice specific to you and your needs.

Some types of buy to let mortgages are not regulated by the FCA. Think carefully before securing other debts against your home. As a mortgage is secured against your home, it may be repossessed if you do not keep up with repayments on your mortgage. Equity released from your home will also be secured against it.

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