Why choose an interest-only mortgage - and how do I repay it? | unbiased.co.uk (2024)

An interest-only mortgage is when yourmonthly repaymentsonly repay the interest on your loan, not the loan itself. We look at what an interest-only mortgage is and how it works.

As an interest-only mortgage is atype of mortgagethat only covers interest, the loan isn’t repaid over time and needs to be repaid in full by the end of the mortgage term or sooner.

Summary

• An interest-only mortgage is when yourmonthly repaymentsonly repay the interest on your loan

• There are a number of things you should do before applying for an interest-only mortgage

• Once you get an interest-only mortgage, it’s important to regularly review your plan

• The most popular use of an interest-only mortgage is tobuy to let

What is an interest-only mortgage and how does it work?

If you take out an interest-only mortgage, you’ll still be charged monthly payments by your lender, but 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 that 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 those 20 years, you’ll still owe £100,000.

When your interest-only mortgage term ends, you will need to repay the loan somehow – either by selling the property, using savings, or taking out another mortgage, known as remortgaging.

How to work out interest only mortgage payments

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 5% mortgage, your annual interest will be £10,008 – so your monthly payment is £10,008 divided by 12, or £834.

Over 20 years, this will mean you pay around £200,000 in monthly payments, and you also must repay the £200,000, making a total of roughly £400,000.

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 £1,320 per month, and at the end of 20 years, you’d have repaid a total of £316,876.

What should I do before applying for an interest-only mortgage?

Before you apply for an interest-only mortgage, there are a few things you should do.

• Compare different types of mortgages: Interest-only mortgages aren’t right for everyone, so be sure to look at your options to see if a different mortgage is better for your circ*mstances. Alternatively, a mortgage broker can help you find the best deal.

• Have a repayment plan: With an interest-only mortgage, it’s vital you have a repayment plan for when your loan term ends. Your lender will likely want to see a plan for how you intend to pay off your mortgage.

• Make sure your credit score is good: When you apply for a mortgage, lenders will look at your credit report and score. If you have a good credit score and no issues flagged on your credit report, your mortgage application is more likely to be successful.

• Can you afford your monthly repayments? You can use a mortgage calculator to check how much your monthly payments will likely be, whether it’s an interest-only or repayment mortgage.

What should I do after I get an interest-only mortgage?

Once you get an interest-only mortgage, it’s important to regularly review your plan to pay the original loan amount when it ends.

So, if you rely on accessing your savings or investments, review these regularly to ensure they are on track.

Remember, your investments can rise and fall in value, so it’s worth tracking performance or consulting a financial adviser.

If you don’t feel confident you can pay off your mortgage when the time comes, talk to your lender as soon as possible.

It’s also essential that you make your monthly payments on time to avoid any fees or impact on your credit score - or, in the worst-case scenario, lose your home.

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

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.

How can I repay my interest only mortgage?

There are several ways you might repay an interest-only mortgage:

Remortgage

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 circ*mstances may have changed.

Sell the property

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.

Use savings & investments

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.

What if I can’t repay my interest-only mortgage?

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 (for example, if it is in negative equity) then your other assets may be at risk.

The pros and cons of interest-only mortgages

Here are the advantages and disadvantages of an interest only mortgage.

The benefits of interest-only mortgages

The main benefit of an interest-only mortgage is that your monthly payments will be cheaper and this means you could potentially borrow more.

If you’re buying your own home, an interest-only mortgage may help you to afforda more expensive propertythan you otherwise could if youswitchto 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 costs lower, and when the term expires, you can just sell the property to repay the loan.

The disadvantages of interest-only mortgages

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 an interest-only mortgage is that the total amount you repay over time will be much higher than a repayment mortgage.

Finally, it is harder to find interest-only mortgage deals, especially if you’rea first-time buyer.

You’ll likely need a bigger deposit and a higher income, which may cancel out any advantage from cheaper repayments.

Who typically applies for an interest-only mortgage – and should I?

The most popular use of an interest-only mortgage is tobuy to let.

Sometimes,people in retirement get an interest-only mortgagethat will be repaid from the sale of their homes when they die.

You can opt for an interest-only mortgage if you want lower monthly payments than a repayment mortgage, but it can be harder to get one.

You’ll need a repayment plan and some lenders may have stricter criteria such as a minimum annual salary to apply for an interest-only mortgage.

Also, interest-only residential mortgages are not ideal for first-time buyers due to stricter lending criteria and bigger deposit requirements.

Ultimately, whether you should get an interest-only mortgage depends on your circ*mstances and if you feel confident repaying the full loan amount at the end of the term.

It’s a good idea to talk to a qualified mortgage broker about whether an interest-only mortgage is right for you, or if you should consider a different one.

Interest-only mortgage FAQs

Here are some more commonly asked questions about interest only mortgages.

Can I switch from interest-only to repayment?

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.

Can I extend my interest only mortgage term?

If you are concerned about being able to repay your mortgage, you may be able to extend the term, but you should talk to your lender as soon as possible.

Can I have a part interest-only, part repayment mortgage?

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.

Learn more: what are part and part mortgages and how do they work?

Is an interest-only mortgage best for buy-to-let?

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.