Interest-Only Mortgages – July 2022

Taking out an interest-only mortgage is one way of keeping monthly repayments low. However, you will be required to pay a lump sum at the end of your mortgage term, and it will down to you to demonstrate how you are going to cover it. Here we explain exactly how an interest-only mortgage works.

What is an interest-only mortgage?

With an interest-only mortgage your monthly repayments cover only the interest charges – in other words, just the cost of taking the loan. The capital you’ve borrowed – ie, the loan itself – is payable as a lump sum at the end of the mortgage term.

How is the capital repaid?

You will need a robust repayment plan in which to build up the cash required to repay the debt. And, since tighter lending rules were introduced as part of the Mortgage Market Review in 2014, lenders have become stricter about what this should look like.

While they will vary by lender, acceptable repayment plans may include the following:

• endowment policies
• stocks and shares
• stocks and shares ISA
• unit trusts
• investment bonds
• pension

You may also be able to submit:

• equity from the sale of a second home
• switching to a repayment mortgage – but be warned your repayments will rise
• in some cases, downsizing the home you live

Buy-to-let mortgages are typically offered as interest-only, as the ‘repayment plan’ is considered to be the investment of the property. Landlords’ outgoings are also usually covered by the monthly rental income.

What kind of mortgages are available?

With the above in mind, you can get an idea of what interest-only mortgage deals are currently available below. Just check the ‘interest-only’ box and then tailor the results according to your preferences – for example, a fix or a tracker deal.

What other types of mortgage are there?

Interest-only mortgages are one of just a handful of mortgage types. Here are the others:

Repayment mortgage: A repayment mortgage is when your monthly repayments cover the interest on the loan and chip away at the capital too. It means that, so long as you keep up with your monthly repayments, the loan will be paid off in full by the end of the agreed term.

Part interest-only: Otherwise known as a ‘part-and-part’ mortgage, this is where you pay the interest on your loan and just a small amount of capital each month. While at the end of the term your mortgage won’t be cleared, there’s a smaller lump sum to pay off compared to a purely interest-only mortgage.

With all mortgage types, the interest on the loan (priced at the agreed rate) is the very minimum payment you will need to make each month to the lender.

Can I get an interest-only mortgage?

Interest-only mortgages used to be a lot more common. But since the 2008 credit crunch – itself caused by ‘bad’ subprime mortgage lending in the USA – the deals have been given out a lot less freely.

In addition to a credible repayment plan, you will now need a sizeable deposit and a significant income. If you are coming to the end of an interest-only mortgage term, it’s also unlikely you will be able to remortgage onto another one.

Will my repayment plan be checked?

Lenders will typically monitor your repayment plan, say after the first 12 months and at the halfway point, to see whether you’re sticking to it – and whether it’s still viable.

Ultimately though, the responsibility for maintaining and checking on your repayment plan lies with you.

What if I am struggling with my repayment plan?

Contact your lender as soon as possible if for any reason you are falling behind on your repayment plan – or you are worried you soon could be. It is likely to discuss alternative options with you such as transferring all or part of your loan onto a repayment mortgage.

Post Covid, the Financial Conduct Authority (FCA) is encouraging lenders to make switching to alternative mortgage deals easier for borrowers.

What if I can’t repay the capital at the end of the term?

If you fall short of the amount needed to cover the capital debt at the time it becomes payable, you may be given the following options:

Remortgage and pay the capital. Although switching to a repayment mortgage will mean paying out more each month, you could keep costs down by arranging to extend the term of the loan and ensuring you are on the best interest rate. However, you will need to prove affordability for the loan.

Use your pension. You can withdraw up to 25% of your pension tax-free when you hit age 55. As an example, that’s £20,000 on a £80,000 pension pot, which might be sufficient to cover any shortfall.

Switch to a retirement interest-only mortgage (RIO). This type of mortgage also allows you to make monthly payments that cover solely the interest. But, unlike an interest-only deal, the capital is only repaid when you pass away or enter into long-term care and your home is sold.

Not all lenders offer ROIs however, and you will need to be aged at least 55 to qualify. Some lenders also impose an upper age limit of age say, 90.

Equity release plan. You could consider a lifetime mortgage. This is where you borrow a lump sum against your home and, while you continue to live there, no repayments are due on it.

Instead, the fixed interest rolls up, is added to the amount you borrowed and repaid in full when you die or go into long-term care and your property is sold.

However, there are serious long-term implications around releasing equity from your property under one of these plans, including leaving behind a smaller inheritance or even none at all. Always consult an independent financial advisor before entering into an agreement.

Sell your property. While it may not be the most attractive option in the short-term, by selling up and downsizing or moving in with family you may free up enough in equity to pay off what you owe.

Pros and cons of an interest-only mortgages

There are both advantages and disadvantages to paying your mortgage on an interest-only basis but whether the type of deal is right for you will depend largely on your circumstances. If you are unsure, seek advice from an independent advisor or mortgage broker.

Pros

• Smaller monthly payments. For example, if you borrow £200,000 at an interest rate of 3% over a 25-year term, you’d pay £500 a month on an interest-only mortgage compared to £948 a month on a repayment mortgage.

• You could make more than the amount owed. If your repayment vehicle performs well, you may have a more than you need by the end of the mortgage term. However, this is not a prospect that should be relied upon and, equally, you could have less.

• More control over your money. While the cash that you are not paying to your lender every month should be feeding a repayment vehicle, ultimately you can choose whether to keep some money back or pay more in.

Cons

• More expensive overall. With an interest-only mortgage, the capital you owe does not reduce which means the interest charged on it doesn’t either. This makes interest-only mortgages more expensive overall than repayment mortgages.

• Risk of a shortfall. Even if you have a viable repayment vehicle in place, it may not perform well and – just as with hundreds of thousands of endowment policies mis-sold in the 1980s and 1990s – you could be left with a shortfall. If you cannot afford to pay the lump sum at the end of your mortgage term, you may have to sell your home.

• More ‘pots’ to manage. You will need to monitor your investment vehicle and won’t have the peace of mind that you will own your home at the end of the mortgage term, providing you meet the repayments.