Interest-only mortgages

What is an interest-only mortgage?

Interest-only mortgages are where you borrow a large sum of money to buy property, but don’t repay that money until the end of the mortgage term. All you may on a monthly basis is the interest charged on it - but as you’re not reducing the balance, the interest charged never reduces.

This can keep your monthly costs low if you have a reliable way of repaying the capital (sum of money borrowed) at the end of the mortgage term, usually in around 25-35 years. It’s often used by landlords making buy-to-let purchases, as it keeps monthly business costs down.

Although less commonly used for residential mortgages, they are available. It might be suitable for someone expecting a large inheritance, or who knows they will be moving abroad and want to sell their property later in life.

We’ll look at how interest-only mortgages work, how to get one, and how to ensure you get the best rates available to you.

How do interest-only mortgages work?

With an interest-only mortgage you still put down a deposit and borrow the rest of the funds needed to buy a property from a mortgage lender. 

Because you won’t be repaying any of the loan over the course of the mortgage term, it’s much riskier for the lender, so you’ll need a larger deposit, usually a minimum of 25%.

You’ll make monthly repayments of interest, which will be charged on the full loan amount for the length of the term - the current average term is 30 years. You can still choose whether you want a fixed or variable interest rate, and in some cases you may be able to make overpayments.

How does this compare to capital repayment mortgages? 

With a repayment mortgage, you pay down the loan amount over the course of the mortgage term. So, you borrow a certain amount, this is split into monthly payments over the full mortgage duration and interest is charged each month.

As your balance lowers, so does the interest, as it’s charged on a lower amount. However, as you’re repaying both the loan and interest, monthly payments are considerably higher than with an interest-only mortgage. Of course, the trade-off is that with a capital repayment mortgage you own the property outright once you’ve finished making payments for the full term.

What happens at the end of an interest only mortgage?

With an interest-only mortgage, you have repaid none of the loan when you get to the end of the mortgage term. This will need to be repaid as a final lump sum, which is not always easy to find - especially when it’s likely multiple hundreds of thousands of pounds.

When you take out the mortgage, your lender will need to agree a repayment plan - sometimes known as a repayment vehicle. Each lender has preferences in the repayment vehicles they accept, but here are some options for repaying the final lump sum of an interest-only mortgage: 

Savings or investments - this could be from property rental in the case of a buy-to-let mortgage, or simply private investments that you expect to mature

Pension - a tax-free lump sum from your pension, assuming the forecasted amount covers it

Selling your property - this is common for landlords, but homeowners won’t always want to sell their family home. However, as you’ll likely have gained equity, it may be possible to repay your mortgage and buy a new home 

Remortgaging - Some lenders will accept a remortgage onto a capital repayment or part and part repayment plan, or in many cases a RIO, (retirement interest-only mortgages) if you’re unable to prove that you could afford monthly repayments on a traditional mortgage

If you find that you’re unable to repay using your chosen method, you may be able to extend the term, but you’d need evidence that the extra time would enable you to pay. 

Who are interest-only mortgages for? 

Interest-only mortgages are most suited to those taking out a buy-to-let mortgage, but can be used for residential mortgages in some circumstances. Although typically you’ll need to be a higher income earner.

Am I eligible for an interest-only mortgage?

Criteria varies from one lender to another, but usually you’ll need to meet the following: 

• Usually 25%+ deposit (although it’s possible to find lenders that accept slightly less if you have other properties to offer as equity)

• Income of £50,000-£75,000+ for a residential purchase - landlords won’t always need to meet a minimum income requirement  

• An approved repayment strategy

• If you’re looking to buy as a landlord, some lenders prefer prior experience, although it is possible to get a mortgage as a first time landlord

• An acceptable property - this is less important for residential, although there are lots of lenders that steer clear of non-standard construction properties - such as a timber framed property. With buy-to-let this will be more relevant, as lenders will want to know that the property is in an in-demand rental area, good condition, and some will prefer single family properties to HMO (houses of multiple occupancy - like student houses)

Are interest-only mortgages cheaper?

On a monthly basis, yes they are, but in the long term, they’re typically much more expensive than capital repayment mortgages. This is because the quantity of interest you pay overall is greater, due to being charged on the full loan amount over a long period of time. 

Capital repayment mortgages have amortisation, which means that they get progressively cheaper as they are repaid. So if you borrow £100,000 with an interest-only mortgage and £100,000 on a capital repayment mortgage at 4.5% interest - you’d pay about £45,700 more back using an interest-only product. 

You can attempt to reduce the additional interest charges, if affordable, by overpaying your mortgage each month. However, be aware of any ERCs involved, as most lenders only allow you to repay about 10% of the outstanding balance per year, without charging you a fee. 

How do I get the best interest-only mortgage? 

The same applies as getting the best rates with any mortgage, although with interest-only mortgages it will depend on the purpose. 

A larger deposit, good credit score and using a mortgage broker, like Mojo Mortgages, to help you search the market quickly and thoroughly is a great jumping off point.

But if you’re specifically looking at buy-to-let, the type of property and tenant you intended to host can also make a difference to the rates offered to you. Some rentals are considered more risky than others.

We can help you focus on those lenders who are able to offer the best rates for the interest-only mortgage you need. And what’s more, our service is completely free of charge, so what do you have to lose? 

What are the advantages of an interest-only mortgage?

• Lower monthly repayments

• May help you to meet affordability for a more costly property due to lower repayments

• Keeps business costs down for buy-to-let

• Can be a good way to buy a property sooner if you’re awaiting a windfall

• Can help you to cope with short-term financial issues if you currently can’t afford a repayment mortgage

What is the Mortgage Charter?

The Mortgage Charter was introduced in response to a dramatic rise in the interest rate environment throughout 2022/23. It set in place a number of easements for those struggling to afford their mortgage repayments in light of large mortgage cost increases, and makes good use of interest-only mortgages. 

Capital repayment customers, under the charter, can temporarily switch to interest-only for a period of six months with their lender, without the need to go through affordability or credit checks. You may also be able to opt for part and part repayments, which is half capital repayment, half interest-only. 

What are the disadvantages of an interest-only mortgage?

• You don’t reduce your mortgage balance over time, so still owe the full amount borrowed at the end of the term - this also increases the risk of negative equity if property value falls

• Your repayment vehicle may not enable you to pay off your loan, for example, if your investment has not appreciated adequately

• You'll pay more interest overall than with a repayment mortgage

• You’ll need a larger deposit and to meet tighter criteria to get one

• If you’re unable to repay the mortgage, you might need to sell your home to cover it, even if you didn’t plan to