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What Is An Interest-Only Mortgage?

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25th Aug 2020 (Last updated on 26th Aug 2020) 7 minute read

With an interest-only mortgage, you pay back interest each month and not capital. You’ll pay back the full value of your home at the end of the mortgage loan. Whilst this isn’t the most popular choice of mortgage, an interest-only mortgage may benefit some more than others. 

Compare My Move work with property industry experts to bring you advice and guidance on the buying, selling and renting a house process. This guide will explain what an interest-only mortgage is, how it works and what the advantages and disadvantages are. 

This article will cover the following:
  1. How Does An Interest-Only Mortgage Work?
  2. What’s The Difference Between Interest-Only And Repayment Mortgages?
  3. What Is The Eligibility Criteria For An Interest-Only Mortgage?
  4. How To Repay An Interest-Only Mortgage?
  5. What Types Of Interest-Only Mortgages Are There?
  6. What Are The Advantages Of An Interest-Only Mortgage?
  7. What Are The Disadvantages Of An Interest-Only Mortgage?
  8. Save On Your House Move With Compare My Move

How Does An Interest-Only Mortgage Work?

An interest-only mortgage means you only pay the interest on your mortgage each month and not the capital. This means that you pay less each month, but will have to repay the full amount that you have borrowed at the end of your arranged term. 

The size of your debt stays the same throughout your mortgage term as each month you pay the interest. It differs from a repayment mortgage as with that type of mortgage you pay both interest and capital each month.

Whilst interest-only mortgages make the cost of buying a house seem more affordable, you will end up paying more in the long run.

What’s The Difference Between Interest-Only And Repayment Mortgages?

A repayment mortgage means you will pay interest and capital each month until you have paid off your mortgage in full. This differs to an interest-only mortgage as you will only have to pay interest per month, paying off the full loan in one lump sum at the end of your term.

If you took out a £200,000 interest-only mortgage over 25 years charging a 2.5% interest rate, then you’d pay £417 a month and £125,055 over the mortgage term. However, you’d still have to pay back your loan of £200,000 at the end of your mortgage term too.

If you took the same deal out with a repayment mortgage, you would pay £897 per month and would have paid off your total loan by the end of the term. At the end of the mortgage term, you would have paid £269,204, instead of £325,055 with an interest-only mortgage. 

Overall, you’d save £55,581 with a repayment loan than if you chose an interest-only mortgage. Whilst you pay less per month with an interest-only mortgage, you will pay more in the long term. With a repayment mortgage, you are always working towards paying off your loan. 

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What Is The Eligibility Criteria For An Interest-Only Mortgage?

Interest-only mortgages are viewed as high risk to many mortgage lenders as you will be paying back more money over time. This means that there is a more strict criteria than with a repayment mortgage. 

Firstly, you’ll have to show evidence of your repayment plan to prove how much mortgage you can afford and pay back. Using Halifax as an example, you must provide evidence of any of the following to show you can afford to repay your loan:

  • Sale of a second home 
  • Stocks and shares
  • Pension
  • Investment bonds
  • Endowment policies 
  • Unit trusts, open-ended investment companies (OEICs)

Another common requirement for an interest-only mortgage is a higher deposit, typically at least 15% of the value of the property. Most lenders will implement a loan-to-value (LTV) of 75% or lower, with some lenders setting a maximum of 80-85%. 

Many lenders will also set an age limit on taking out an interest-only mortgage so there is also an upper-age limit on when you must pay back your capital. Some interest-only lenders will accept applicants that are retired, such as a retirement interest-only mortgage where applicants must be over 55.

How To Repay An Interest-Only Mortgage?

The most common repayment plans for an interset-only mortgage are selling your property, using pension or earning from an investment.

Sale of property - 

You can pay off your capital by selling your house and downsizing to a smaller property. You’ll pay off the loan by using the equity that was hopefully built up on your property over time. Alternatively, many lenders will accept the sale of a second property as a repayment plan. 

Many lenders will require you to have a minimum equity value of between £100,000 and £250,000. You’ll also need to provide evidence of your equity and the value of your home or second home. 

Pension lump sum - 

Another repayment option is paying off your loan with your pension. If you’re over 55 you will be allowed to use a 25% tax-free portion of your pension to repay your capital on your interest-only mortgage. 

It should be noted that the amount you can use from your pension will vary depending on which lender you use. 

Investment bonds/stocks and shares - 

Another popular interest-only mortgage repayment plan is to use earnings from investment or stocks and shares. You’ll have to provide evidence of your investments by presenting share certificates or account statements. 

The affordability assessment with using investments/stocks as a repayment plan will vary depending on lender. Some lenders will judge your repayment capability based on 80% of the latest annual valuation on (variable) asset amounts, whilst others will base their judgement on 50% of current investments. 

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What Types Of Interest-Only Mortgages Are There?

We’ve listed some of the most popular interest-only mortgages and who they are best suited to. 

Retirement Interest-only Mortgage -

An ideal mortgage for the over 50s, a retirement interest-only mortgage means you only pay the interest monthly and the outstanding capital must be paid off when you sell your house, move into long term care or when you pass away. 

It differs slightly from a normal interest-only mortgage as you only have to prove that you can afford to repay the monthly interest repayments and not the capital. You should have a reliable and regular income that will prove this. 

Interest rates are usually higher than traditional mortgages, ranging from 2.74% to 4.55% and you must be over 55 to apply. 

Buy-to-let Mortgage - 

Buy-to-let mortgages are designed for those buying property to let it out. You only pay the interest accrued each month and will pay off the capital borrowed at the end of the mortgage term.

As buy-to-let mortgages are seen as a higher risk to lenders, you will need a higher deposit as well as facing a higher interest rate applied to your loan.

What Are The Advantages Of An Interest-Only Mortgage?

If you are experienced investor or have savings, then an interest-only mortgage may be for you. We’ve listed the benefits on an interest-only mortgage below.

  • You’ll pay less in monthly payments as you only pay the interest accrued
  • You don’t have to pay back the capital until the end of the mortgage term
  • Your low monthly payments give you more money to invest or save. It should be noted that the extra money you have monthly should be used to save towards paying back your loan at the end of the mortgage term.

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What Are The Disadvantages Of An Interest-Only Mortgage?

Whilst interest-only mortgages are suited to some people, they come with more disadvantages than benefits. Below are the cons of an interest-only mortgage.

  • You will have to pay back more overall as you are paying interest each month and then will have to pay back the loan in full at the end of the mortgage term too.
  • You might pay a lot more in interest if mortgage rates rise
  • You might not earn or save as much as you plan to in order to pay off the loan in full 
  • You won’t increase any equity in your home during the mortgage term 

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Disclaimer

All data, research, facts and figures have been taken from reputable sources and government data that was accurate at the time of writing. Mortgage criteria, interest rates and policies change regularly and vary depending on the lender and type of mortgage you have. You should speak directly to your mortgage lender for clarification. It should be noted that your home may be repossessed if you cannot keep up with your mortgage payments.
Martha Lott

Written by Martha Lott

Having written for Huffington Post and Film Criticism Journal, Martha now regularly researches and writes advice articles for everything moving house related.