Interest Only Mortgages

Paying off just the interest in with mortgage payments, for a set period, is a great way for homeowners to increase cashflow. There are many interest-only mortgages on the market, which offer different ways of making up the full sum of the loan when the mortgage term is complete.

Find out more about interest only mortgages and how they work.

What is an Interest Only Mortgage?

An interest only mortgage is where the borrower takes out a loan for a home and pays off just the interest every month. The ‘capital’ portion (i.e. the money used to purchase property) is paid in full at the end of the mortgage term. A typical mortgage term length could be anything from 20-30 years.

Am I Eligible for an Interest Only Mortgage?

  • You will need to prove that you have a credible ‘repayment vehicle’ for the mortgage capital repayment. If you are a highly-paid employee or profitable business owner, you may be accepted for an interest only mortgage.
  • A further point on affordability, if you have access to a substantial pot of savings, but have a low-paying job, you may be rejected for an interest only mortgage. This is because the lender will ‘stress test’ your application to ensure that your monthly income could handle an increase in mortgage interest rates, without putting you in a bad financial situation.
  • Those seeking to buy a house to rent out will find that there are many interest only buy to let mortgages on the market. To find out more about buy to let mortgages, take a look at our Buy to Let Mortgage Guide.

How is an Interest Only Mortgage Repaid?

As mentioned previously, you will need to make every monthly mortgage interest payment. Also, you will need to set up a ‘repayment vehicle,’ which your lender agrees will make a credible form of payment for the mortgage capital at the end of the mortgage term. Examples of credible repayment vehicles include;

  • A stocks and shares ISA, which the mortgage holder contributes to on a regular basis.  
  • Unit trusts/ Open Ended Investment Companies (OEIC)
  • Investment Bonds
  • Pension Savings
  • For Buy to Let properties, the sale of a mortgaged property may be used to pay off the loan capital. However, this may limit the maximum mortgage permitted to 75% loan to value and the property sold may have to be worth a certain amount of money (for example £200,000).
  • Endowment policies
  • Other savings

In terms of the interest rate itself, you can choose deal which pays interest at a fixed, tracker or discount rate. See our Guide to Mortgage Types for more information.

Please note: Some mortgage plans can be repaid on a part interest only, part repayment basis.

Let’s Look at an Interest Only Mortgage Example

Jason and Camilla took out a £100,000 mortgage with a 25-year term, paying interest only at a rate of 5%.

If they had taken out a standard repayment mortgage, for the same amount at the same interest rate, their payments per month would have been £591.27. Currently, their deal puts their payments at 416.66 per month. At the end of the mortgage deal, they would have paid approximately £47,000 more in interest than if they had gone with a repayment deal from the start.

However, as Jason anticipates that his income will rise in a few years’ time, they instead decide to stick with interest only payments for two years and then remortgage to a fixed repayment plan.

What are the Benefits of an Interest Only Mortgage?

  • Lower Monthly Repayments – A reason interest only is a common feature of buy to let mortgages is because lower monthly repayments equal greater cashflow for mortgage holders. If you’re a new landlord, having more money at the start of the term can help you make home improvements or hire a letting agent, for example.
  • Investments – With the money saved by not making monthly capital repayments, you can use the money to invest elsewhere and possibly even generate a profit. The money generated from investments can be saved to pay off your mortgage at the end of the term, or used for anything you wish.
  • Extend or Switch to Repayment – When taking out an interest only mortgage, if you are accepted and then run into difficulty, you can renegotiate with your lender in many cases. If you think that you cannot cover the capital at full term, notify your lender as early as possible and see if they can move you to a part repayment, part interest only deal, or extend your term, to help you avoid a mortgage shortfall. Please note: Changing your interest only mortgage, may incur fees.
  • Rising House Prices – If you choose the repayment vehicle to be the sale of your home, and it has risen significantly in value, you may be able to pay off your mortgage with funds to spare.

What are the Pitfalls of an Interest Only Mortgage?

  • Shortfalls – If the repayment vehicles used for the mortgage capital are not worth enough to cover the loan at the end of the term, then this is known as a ‘mortgage shortfall.’ Using a repayment vehicle, for some, may be a bit of a gamble. Before taking out a mortgage loan, you should carefully examine your repayment options.
  • More Interest Overall – When taking out an interest only mortgage, your monthly mortgage repayments are ‘serving’ the interest owed on the capital portion of the loan. In contrast, a repayment mortgage reduces the capital bit-by-bit and so the interest you pay serves the amount still outstanding. Therefore, those on an interest only mortgage will pay more in interest overall, compared with those on a repayment mortgage.

What are the Alternatives to an Interest Only Mortgage?

Repayment Mortgage – Taking out a mortgage where the capital is repaid over time could be a safer bet for those who fear their investments and/home sale will result in a mortgage shortfall at the end of the mortgage term. You can then choose to pay interest at a fixed, capped, discounted, tracker or standard variable rate.

Offset Mortgage – This is where funds used in a savings account can be ‘offset’ against the interest owed on a mortgage loan. For example, if the mortgage was £300,000 and you had £50,000 of savings in an offset account, you would pay interest on £250,000 of the loan rather than the full £300,000.

If you need advice before applying for an interest only mortgage, get in touch with an independent mortgage broker. They can help you weigh up your options and find the best deal for you with free, no-obligation quotes. Contact a mortgage broker to get started.

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