Interest-only mortgages were more commonly used for residential properties before the 2008 financial crash. Nowadays it's much rarer to use them to buy a home to live in, but they're often used for buy-to-let properties.
How do interest-only mortgages work?
An interest-only mortgage works the same as any other mortgage - the only exception is how you pay back the loan. You can still choose a fixed-rate or variable-rate of interest and the type of deal you prefer.
When you get an interest-only mortgage, you’ll need to agree to a final repayment plan with the lender. This is so they're confident you can repay the loan at the end of the mortgage term.
You make monthly interest repayments for the length of the mortgage term. The interest is charged on your full loan amount each month.
At the end of the mortgage, you pay off the full loan balance using your agreed final repayment plan.
Each lender accepts different repayment plans, depending on what they prefer. These might include:
- Investment or pension funds
- Remortgaging onto a capital repayment mortgage
- Selling the property – popular with buy-to-let landlords who have less attachment to the property
- Selling something valuable that you own
Most lenders like to check regularly that your repayment plan is going to be valuable enough to repay the debt at the end of the mortgage term. This could be by:
- Checking that your home is increasing rather than decreasing in value
- Monitoring the growth of your investments or pension plan – whatever you’ve chosen to repay the loan with
What's the difference between interest-only and repayment mortgages
The biggest difference between an interest-only and a repayment mortgage is how you pay them back.
With a capital repayment mortgage, you repay some of the loan balance and interest each month. As long as your interest rate stays the same, the interest charges reduce with your loan balance each month until you've eventually repaid it all.
At the end of the term, you own the property and have nothing more to pay.
With an interest-only mortgage, your balance doesn't reduce over time because you’re not repaying it. The interest you owe is the same every month – so long as the interest rate stays the same.
So you end up paying more interest overall with an interest-only mortgage, even though the monthly repayments are smaller.
You still need to repay the money you borrowed before you own the home.
Can I get an interest-only mortgage?
It depends on your personal circumstances and what you want the mortgage for. For a buy-to-let property, you'd normally use an interest-only mortgage.
If you want an interest-only mortgage to buy a residential property – a home that you live in yourself – the criteria are stricter. So it's more difficult to get an interest-only mortgage if it’s to buy your own home.
If you want an interest-only mortgage, you'll need to meet the lender's affordability criteria and minimum age requirements. You’ll also usually need to have:
- A larger deposit
- A minimum income requirement
- An approved repayment vehicle
Larger deposit – lenders limit the loan to value (LTV) of this type of mortgage to around 75%. The LTV is the percentage of the property value they will lend – the rest would need to be made up with a deposit.
This means that your deposit (or equity if you're remortgaging) will usually need to be at least 25% of the property value.
Minimum income requirement – many, but not all, high street lenders require you to earn a minimum income before you're eligible for an interest-only mortgage. How much varies between lenders, but is often £50,000-£75,000 for single applicants or a £100,000 combined income for joint applicants
If you’re not on a high enough income, your options are more limited.
Approved repayment vehicle – different lenders accept different repayment plans (which they often call a repayment vehicle). Some don't allow you to rely only on the sale of the property to repay the full mortgage, especially if it's your residential home.
If you want to use an ISA, pension or investments as your repayment plan, you'll need to provide evidence of them. Some lenders may let you repay the loan by selling a buy-to-let property, or business premises.
What are the advantages and disadvantages of interest-only mortgages?
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Cheaper monthly repayments – if you’re a landlord this can be helpful in keeping business costs low
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Opportunity to invest – lower repayments leave you with more cash to invest in other ways, which means you could get a better financial return overall
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You pay more interest overall – as interest charges don’t reduce over time, the total interest you pay is higher than on a capital repayment mortgage at the same interest rate
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It’s more difficult to qualify for – this type of mortgage is seen as riskier by lenders, so the criteria are stricter
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Fewer lenders offer them for residential purchase – this means less choice and competition, so usually higher interest rates
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Your repayment method could fail – if you’re relying on an investment or property to repay the loan at the end of the term, you could experience a shortfall
Interest-only mortgages FAQ
What happens at the end of an interest-only mortgage term?
When the term ends, you need to repay the full amount that you borrowed to buy the property when you got the mortgage.
In some cases, lenders may let you extend the term or remortgage if you can't repay the loan at the time.
This depends on your personal circumstances, and you still need to commit to repaying by their extension date.
Can you pay off an interest only mortgage early?
You usually can, yes, but you’ll probably have to pay early repayment charges (ERCs).
ERCs can be as much as 5% of the outstanding balance on your mortgage. With an interest-only mortgage, this would mean 5% of the total amount you borrow.
What repayment plans are available for interest-only mortgages?
The plan you use may be different depending on whether you’re using the interest-only mortgage for a residential or commercial reason.
It also depends on which repayment types your chosen lender allows. These include:
- Inheritance
- Sale of the property you’ve bought
- Sale of other assets (high-value items like buy-to-let properties)
- Investments
- Savings
- Regular overpayments – usually capped at 10% of the loan balance per year
- The lump sum payment from your pension plan
- Remortgaging onto a capital repayment mortgage or part and part mortgage
- Remortgaging onto a retirement interest-only mortgages (RIO) if you’re 55+
- Equity release lump sum if you’re 55-65+
What happens if I can’t repay my interest-only mortgage?
Some lenders may allow you to extend your mortgage, if you’re able to prove that you can repay the loan at a later date.
You may also be able to remortgage with your existing lender (known as a product transfer) or another lender.
This will probably need to be a capital repayment or a part interest-only, part repayment mortgage (known as a part and part mortgage).
As a final option you could sell the property to cover the repayment. If your home has decreased in value since you got the mortgage, you’ll need to pay the difference.
Can I change my interest-only mortgage to a capital repayment mortgage?
Yes, you can. In fact, most mortgage lenders allow you to switch from an interest-only to a repayment mortgage without paying any fees.
This is because it’s in their best interest as you’ll be moving to a repayment method that is less risky to them.
This is also why it's more difficult to switch in the opposite direction from repayment to interest-only, unless it’s a temporary move.
Learn about different mortgage types
Mortgages
are a type of loan used to buy a property. The mortgage is secured against the value of the property.
Buy-to-let Mortgages
aren't that different from a regular mortgage. But there are some important differences.
YOU SHOULD THINK CAREFULLY BEFORE SECURING OTHER DEBTS AGAINST YOUR HOME/PROPERTY. YOUR HOME/PROPERTY MAY BE REPOSSESSED IF YOU DO NOT KEEP UP REPAYMENTS ON YOUR MORTGAGE.
The Financial Conduct Authority does not regulate mortgages for commercial or investment buy-to-let properties.
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