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What Is An Interest-Only Mortgage?

Martha Lott

Written by Reviewed by Emma Lunn

25th Aug 2020 (Last updated on 7th Apr 2021) 6 minute read

Interest-only mortgages offer cheaper payments than repayment mortgages, but it’s important to understand the pitfalls of this type of mortgage before taking one out.

With an interest-only mortgage, you only pay back interest on your loan each month, not any of the capital, so you’ll need to figure out a plan to repay the capital at the end of the term.

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. Learn More About Mortgages

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 you will have to repay the full amount that you have borrowed at the end of the term. 

The size of your debt stays the same throughout your mortgage term as each month you pay the interest. An interest-only mortgage differs from a repayment mortgage where 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. At the end of the term, you won’t owe the mortgage lender any money and you’ll own your property outright.

An interest-only mortgage, you only pay the interest on your loan each month. You’ll need to repay the capital at the end of the term.

Interest-only mortgages mean cheaper monthly payments.

For example, if you took out a £200,000 mortgage at 2.5% over 25 years, and repaid it on an interest-only basis, you’d pay £417 a month and £125,055 over the mortgage term. After 25 years you’d still owe the lender £200,000.

If you took the same deal out with a repayment mortgage, you would pay £897 a month and £269,204 over the term of the mortgage. After 25 years you’d own the property outright. This means you’d save £55,581 by choosing a repayment mortgage over 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?

Mortgage lenders view interest-only mortgages as high risk as you need to repay the capital at the end of the term. The lender will want to know how you plan to do this.

Different lenders accept different repayment vehicles. These might include: 

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

To be eligible for an interest-only mortgage you normally need a higher deposit than normal, typically at least 15% of the value of the property. This means taking out a mortgage at 85% loan-to-value (LTV).

Many lenders will also set an age limit on the maximum age you can be at the end of the mortgage term.

Other lenders specialise in older borrowers by offering ‘retirement interest-only’ mortgages to people aged over 55.

How To Repay An Interest-Only Mortgage?

The most common repayment plans for an interest-only mortgage is selling your property or using your pension or investments to repay the debt.

Sale of property - 

You can pay off the capital by selling your house.

If the house has risen in value since you bought it, you can then use the equity to buy a smaller/cheaper property.

Alternatively, many lenders will accept the sale of a second property as a repayment plan. For this to be accepted, you might need minimum equity 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 can withdraw 25% of your private pension as tax-free cash. You can then use this to repay the 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 the lender. Some lenders will judge your repayment capability based on 80% of the latest annual valuation, 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 55s, a retirement interest-only mortgage means you only pay the interest each month and then 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 on 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 people buying property to let to tenants.

Many landlords borrow on an interest-only basis, with a plan to either sell the property at the end of the term or use the equity on other properties to pay off the capital. 

As buy-to-let mortgages are seen as a higher risk to lenders, you will need a bigger deposit than on a residential mortgage. Interest rates also tend to be higher than on residential mortgages.

What Are The Advantages Of An Interest-Only Mortgage?

If you are an experienced investor or have savings, then an interest-only mortgage may be for you. We’ve listed the benefits of 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
  • Low monthly payments give you more money to invest or save

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What Are The Disadvantages Of An Interest-Only Mortgage?

While 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 pay off any of the capital borrowed during the mortgage term 

Learn More About Mortgages

This has been part of our mortgages and deposits guide. The next article in our series will look at guarantor mortgages, explaining all the important information for that type of mortgage. To find out more read guarantor mortgages.

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.

Emma Lunn

Reviewed by Emma Lunn

Freelance Personal Finance Journalist,

Emma Lunn is an award-winning journalist who specialises in personal finance, consumer issues and property.