Interest only mortgage
This is the less common of the two main types of mortgages that you can apply for. There are now very specific reasons for having this type of mortgage and restrictions for who can be approved for one.
In this section we will explain how interest only mortgages work and how they might or might not be suitable for you.
What is an interest only mortgage?
Interest only is a type of mortgage, in which a lender will agree to lend on the basis that every month, the borrower pays only the interest element of their loan. You are then left with paying off the capital element at the end of the mortgage term, which on average will be 25 years.
This means that the monthly repayments will be lower for the borrower than a repayment mortgage, where both capital and interest are paid. Smaller repayment amounts make this an appealing mortgage type for those wanting lower monthly outgoings.
The main purpose of this mortgage type is for Buy to Let property investors or landlords. This is a way to be more tax efficient for investors and can help to manage cashflow for landlords.
With an interest only agreement, the borrower is responsible for making sure that they have sufficient funds to repay the capital at the end of the term.
Most lenders will require a substantial deposit plus proof that the applicant has a financial vehicle in place. This is os they can be certain that the applicant will be able to repay their mortgage when the time comes to do so.
If lenders don’t think the loan is financially viable, they may refuse to provide a mortgage. Even if they do approve the mortgage, they will most likely check in at least once if not more during the mortgage term. This is to make sure the plan for repayment is still on track.
Pros and cons of an interest only mortgage
As with any mortgage type, there are numerous benefits and disadvantages to be considered when considering putting in an application. These include:
|Lower monthly repayments compared to repayment mortgages.||Lenders will need to see an acceptable savings plan before agreeing to an interest only mortgage – to ensure the borrower will be able to pay the capital back.|
|Good for landlords who will have rental income to help build savings to repay the capital at the end of the mortgage term.||Lenders will occasionally check in to make sure the financial plan for repayment is still on track to be able to afford to repay the loan. It is best to make sure it is in case this happens.|
|Allows for a long time to renovate/improve the property. This can lead to a potential profit if the property is worth more than when it was bought – if sold at the end of the mortgage term.||It is worth keeping an eye on the housing market. It’s possible there could be a loss when selling if house prices decrease, which isn’t ideal if relying on the sale of the property to repay the loan.|
|If the mortgage is taken out as buy to let, having lower repayments is beneficial at times between tenants where there is no income from this property||Unlike with a repayment mortgage, the overall mortgage amount owed will not decrease over time, as it is only the interest covered by the payments not the capital|
Reasons to take out an interest only mortgage
The most commonly approved reason for taking out a mortgage on an interest only basis is when a person wants to take out a buy to let mortgage.
This mortgage type will equal lower monthly expenses than what can be expected from a capital and repayment mortgage. This is especially useful for a landlord or investor with multiple properties to look after.
Of course, you can take out a mortgage on an interest only basis for other reasons such as buying a home for yourself rather than as an investment.
Generally though, you will need very solid proof of having financial means to repay the full amount of the mortgage at the end of the term. This could be through various investments such as ISAs, other property to use as equity etc.
Whether a lender will agree to provide funds will depend on various factors such as credit score, annual income etc. More often than not, a repayment mortgage may be more likely to be approved for someone looking to simply buy themselves a home – especially first time buyers.
For more information on repayment mortgages, check out our page on the topic HERE.
Interest only vs repayment mortgage
Interest only is not the only type of mortgage available on the market. In fact, the more commonly taken out mortgage is known as a repayment or “capital and repayment” mortgage.
A repayment mortgage will generally have higher monthly repayments. This is because these payments will go towards paying off the capital of the loan as well as the interest.
The amount paid per month for both types will vary depending on the interest rate of the mortgage agreed (fixed-rate, standard variable rate etc.) and the individual lender.
Below we have a table highlighting the advantages and disadvantages of both interest only and repayment mortgages to allow for an easy comparison between the two:
|Advantages||Lower monthly repayments compared to capital and repayment mortgages due to only paying the interest amount. A popular choice for landlords as they can save a portion of the rent money to pay off the capital owed of the loan at the end of the mortgage term.||Paying less interest over time as the amount owed decreases. At the end of the mortgage, all of the capital plus interest should be paid off equalling no outstanding debt.|
|Disadvantages||All of the capital will still be owed at the end of the mortgage term as it is only the interest that is paid off with the monthly repayments. Usually, an approved repayment plan will need to be in place, so the lender knows you will be able to repay the capital. If the proposed plan is not satisfactory, the lender may refuse to approve the mortgage.||Higher monthly repayments than with interest only mortgages. Initially, the payments mainly go towards paying the interest – meaning it can take a few years for the amount of capital owed to start to decrease.|
Types of interest only mortgage
As with any mortgage there are several options on mortgage terms, interest rates paid etc. depending on the bank or lender involved. More often than not, comparison between lenders is key to securing the best possible mortgage rates.
As with repayment mortgages, it is possible to have options in terms of the mortgage interest rate. This is especially important to consider when it is only the interest that will be being paid, as this rate will be the entire monthly expense. The most common types of interest rate are:
- Fixed-rate mortgage: the interest rate will not change for a fixed period of time, hence the term ‘fixed-rate’. Common fixed rate terms can be anywhere between 2 years – 5 years.
- Standard Variable Rate mortgage (SVR): the interest rate can either decrease or increase over time depending on the base rate of the individual lender, hence the term ‘variable’ rate. Lenders can change these rates at their own discretion.
- Tracker mortgages: the interest rate will track the Bank of England’s set interest rate and adjust to that rate whenever it changes.
How much will my interest only mortgage repayments be?
As the term ‘interest only’ indicates, the mortgage repayments from this type of mortgage will only cover the interest from the loan.
This means the monthly payments will be a lot lower compared to a repayment mortgage. This is because with a repayment mortgage the borrower will also be required to pay back a portion of the capital per month as well.
With these mortgages, the amount of the monthly repayment will depend on how the interest rates of the particular lender that the mortgage is with. It will also depend on what type of interest rate mortgage term has been agreed to.
Unlike with a repayment mortgage, the overall amount borrowed shouldn’t affect the monthly costs as it is only the interest that is being paid for on a month-by-month basis. The overall capital borrowed will be paid off at the end of the mortgage term.
If for example, someone has taken out a mortgage worth £100,000 with a 3% interest rate, the annual interest would equal out to £3,000. Dividing this figure by 12 would mean the repayments would be £250 per month.
It is a good idea to check with the lender whether they will offer a fixed rate mortgage. This will hold the monthly repayments at a certain interest rate amount for a set period of time.
The other option would be to agree to a variable rate mortgage, where the repayment amount could increase or decrease depending on the interest rate charged by the lender at the time.
This can be beneficial if interest rates drop as the monthly repayments will then be lower. It is worth considering though, that there is a risk that monthly payments could increase if the interest rate goes up rather than down.
Interest only lifetime mortgages
There is a type of mortgage known as an interest only lifetime mortgages. This mortgage deal is specifically meant for equity release.
This type of mortgage allows the borrower to loan an amount against the value of their home releasing equity from the property to boost their finances if needed. This could be for multiple reasons such as debt consolidation or to fund property renovations.
With an interest only lifetime mortgage most lenders will only loan out a maximum loan to value (LTV) payment of 40-50% of the total of the original mortgage deal.
The interest rates for this type of mortgage are usually fixed term, meaning a set payment every month.
There are also plans known as home reversion plans, which are similar to lifetime mortgages. With this you would sell all or part of the property for a cash lump sum or monthly income – sometimes both.
The downside to this is that the portion of the property sold no longer belongs to you, making a lifetime mortgage a more appealing option for most people.
Retirement interest only mortgages
Similar to interest only lifetime mortgages, there are mortgage schemes that are designed specifically with retirement in mind. It is one of several equity release plans that are aimed at those over 55.
A retirement interest only mortgage is very similar to a standard interest only mortgage but is geared more towards equity release.
The homeowner can borrow against their existing property to boost their finances by releasing equity from their home. This can be useful for those who are retired to supplement their income.
This mortgage type is aimed at over 55s. The borrower will have to pass an affordability assessment before being approved for the mortgage, which will look at their income (most likely a pension scheme and, if applicable other benefits received).
With this mortgage type, the amount borrowed only usually has to be repaid under two circumstances. These are if the homeowner passes away or has to move into long term care resulting in the sale of the house.
Buy to let mortgage interest only
An interest only buy to let mortgage is the one that is most commonly approved by lenders. Someone taking out a buy to let mortgage will usually be a landlord or investor who will have renters staying in the property. It is more common to apply for a repayment mortgage if wanting to buy their own home.
This additional revenue stream will look more favourable to lenders. Some lenders may otherwise be concerned about the chance of the borrower defaulting on paying back their loan at the end of the mortgage term.
With tenants in place and consistent rent payments, this allows the borrower to save or invest the profits they are making sensibly. Ideally, they should then have enough money set aside to repay the mortgage at the end of its term.
The borrower may even choose to sell the property at the end of the term of their mortgage. If they have renovated the property in the years since buying it, it may be worth more than the original mortgage deal.
This could lead to a profit upon selling, even after repaying the loan. For investors, this is an ideal outcome and can allow them to reinvest the money made into a new property if they wish to.
For information on buy to let mortgages CLICK HERE.
End of interest only mortgage – what happens?
When the mortgage term is nearing its end, the lender will usually be in touch around 12 months before repayment is due. They will then get in touch 6 months prior to the end of the term and then once more after that.
At this point it is possible to request a ‘redemption statement’ from the lender which will detail the exact amount still owed. Usually this will be the full value of the mortgage taken out, though it can be less if the provider allowed for overpayments at an earlier point during the mortgage term.
There will have been a repayment plan in place prior to the mortgage being approved. Ideally at the point of 12 months before repayment, this should be on track to cover the amount of capital owed.
If not, there are options available to make repayment possible which we will detail in the next section.
What if I can’t pay off my interest only mortgage?
Various things can happen over the years since taking out a mortgage – especially one with a 25-year term. There can be unexpected expenses or bad investments. This could lead a buyer to be worried they may be unable to repay the full amount of the amount borrowed at the end of the mortgage term.
The best advice to anyone concerned by this would be to take action immediately rather than leaving things any longer. Get in touch with a financial advisor and assess the options available, as the longer it is left the harder it may be to sort out.
There are several options available that may help with repaying the capital on a mortgage:
- Switching mortgage type to a repayment mortgage: This will allow for gradual repayment of the capital. It is definitely possible to switch from one mortgage type to the other, either with the current lender or a new one depending on where the rates are most favourable.
It would be best to remortgage to a repayment mortgage sooner rather than later, if concerned about possibly defaulting on paying back the amount borrowed.
- Overpayments: It is possible to arrange overpayments with certain mortgage lenders, meaning paying back more than the minimum payment required per month. This could be one or two larger lump sums or regular overpayments.
If worried about affording the end capital repayment, it is worth thinking ahead and getting started on overpayments, whenever this is affordable. This may be a good idea to lower the amount of capital needed to be repaid at the end of the mortgage term.
- Having a solid financial plan in place: The best option available is to ensure a solid plan for repayment from the start, that is consistently managed and reviewed to make sure it will pay off long term.
This could be through ISAs, rent payments from tenants, pensions or other assets. Speak to a financial adviser for more information or if concerned that any investments are not going to pay off as intended. If the initial financial plan is no longer viable, it is best to put a new one in place as soon as possible.
Overpaying an interest only mortgage
As the name suggests an interest only mortgage only ties you into paying for the interest on the mortgage every month – but it is possible with some lenders to pay more than this.
This can decrease the amount of capital that will be needed to be repaid in full at the end of the mortgage.
Speak to the individual bank or other lender that the mortgage has been loaned through. It could be possible to arrange to pay a large lump sum to the lender, if having inherited money from a life insurance policy for example.
The option to arrange smaller regular overpayments if these are affordable may also be available. Again, both of these will depend on the policies of the lender.
It is important to bear in mind that not all lenders will allow overpayments, with the chance of incurring fees for overpaying.
Early repayment charges (ERC) can be written into a mortgage to discourage borrowers from ending their mortgage terms early.
This is because this scenario would cause the lender to lose out on the interest payments they would be expecting as profits over the full term of the mortgage.
You may be unsure as to whether a new or existing mortgage agreement has early repayment charges as part of the contract. it is best to speak to the mortgage provider directly for clarity on this.
Interest only mortgage calculator UK
With interest rates being flexible depending on the provider, it makes sense to want to try and calculate the possible amount paid per month. This will allow you to find the best mortgage rates available.
There are dedicated calculators available online for all sorts of mortgage types, even interest only ones.
They will be able to work out how much a monthly repayment would be depending on the overall mortgage amount that has been loaned and the interest rate applicable to the individual mortgage.