How does an interest only mortgage work?

Interest only mortgages work in a different way to standard repayment mortgages.

You only pay interest, so your monthly payments will cost less. 

But you’ll either need to have the money set aside to pay off the rest of the mortgage when it ends or have a sufficient repayment vehicle lined up.

Interest only mortgages are a bigger risk to lenders. So there are strict guidelines to make sure you only get an interest only mortgage if it’s right for you.

Some high street lenders and some smaller firms offer interest only mortgages. They'll often need a deposit or equity of at least 25%.

Before you get one, you’ll need to show lenders how you plan to pay back the loan. This is the ‘repayment vehicle’.

Differences between interest only mortgages and repayment mortgages

With an interest only mortgage you:

  • only pay back the interest

  • pay the rest of what you borrowed at the end of the mortgage term

With a repayment mortgage you:

  • pay part of the loan and the interest back each month

  • will have paid everything back at the end of the term if you’ve made all your payments

So if you borrowed £150,000, over 25 years at an interest rate of 4% you’d pay:

  • £500 a month with an interest only 

  • £791 a month with a repayment mortgage 

With interest only, you’d still owe the £150,000 at the end of the mortgage term.

Compare interest only mortgages

Compare interest only mortgages and see how your monthly payments would change depending on the initial period, total mortgage length, your deposit and how much you want to borrow.

After you choose an interest only mortgage deal, one of our expert mortgage brokers can check whether you're eligible and help arrange the mortgage for you.

Your home may be repossessed if you do not keep up repayments on your mortgage.

Your loan to value is 75.00%

Types of interest only mortgage

A fixed rate mortgage means your repayments will stay the same for a fixed time. This is good for stability and helps you plan your finances.

At the end of the initial fixed period, you’ll go back to the standard variable rate (SVR). This could mean your payments go up but you can remortgage to see if you can find a new deal.

A tracker mortgage follows The Bank of England’s interest rate. This gives you some certainty about rate movements.

Your repayments will rise as rates rise, but they’ll also fall if rates fall. Trackers are often a few percentage points above the rate they’re tracking.

An offset mortgage links your mortgage loan to a savings account.

You do not get interest on your savings but they go to offset the loan. So the more you save, the less you pay on your mortgage.

You can also put the money in your savings account and use them to pay off the capital at the end of the term.

Retirement interest only mortgages let you borrow money against your property. 

They’re good if you’re planning to downsize or remortgage. 

Learn more about retirement interest only mortgages.

Interest only mortgages are more common for buy to let mortgages.

Buy to let interest only mortgages are useful if you want to pay less each month. 

They’re good if you’re planning to sell this or another property to pay off the mortgage in full at the end of the mortgage term. 

Learn more about buy to let interest only mortgages.

Advantages of an interest only mortgage

The main benefit is that your monthly payments are much lower than a repayment mortgage.

With an interest only it’s also:

  • less likely that you’ll get into mortgage arrears 

  • cheaper to get on the property ladder

  • likely you’ll be able to make overpayments if you have the money. Your overpayment is taken from the capital you owe, this lowers the debt you have to pay at the end

There could be tax advantages with interest only mortgages for buy to let investors.

Disadvantages of an interest only mortgage

The main downside is that you'll still owe the full amount of what you borrowed. This is because you’re only paying the interest on your loan.

With an interest only you may:

  • need to use savings, investments, or other assets to pay off the total loan amount at the end of your mortgage term. This could leave you short of cash for retirement or other projects

  • still not have enough to pay off all the debt if you put money into an investment plan over the life of the loan

  • not be able to repay your original mortgage loan at the end of the term

  • not be able to pay off the loan afterwards if you plan to sell at the end and downsize. It's not a guarantee that property prices will increase. You’d then have to sell the property and pay the difference in value to repay the mortgage

  • end up in negative equity where your mortgage is more than your property is worth

  • pay more interest in total over the term of your mortgage compared to a repayment mortgage

Why switch to an interest only mortgage

Monthly payments might be lower. But they can still go up if the interest rate does when you're on a variable rate mortgage.

It’s harder to get an interest only mortgage since the 2008 financial crisis.

Lenders now ask to see evidence of how you plan to repay the loan when you apply for a mortgage.

A promise of a large amount of money or inheritance in the future is not enough. 

Lenders will expect to see an approved investment vehicle such as an ISA. They'll check to see that it's on track to pay off the loan when you remortgage.

Managing an interest only mortgage

If you already have an interest only mortgage, you’ll need to make sure you can pay off the loan at the end of the term. 

It’s a good idea to start putting cash aside if you do not have a repayment vehicle.

Remortgaging may make it easier to pay off your mortgage over time. 

If you can afford to, it may be worth:

  • switching your interest only mortgage to a repayment mortgage 

  • considering a part interest only, part repayment mortgage so that you can start paying some capital without your monthly payments going up too much

Be careful of any early repayment charges you’d have to pay if you switch mortgage deals.

Some lenders make it easier than others to switch your mortgage deal with them. It's worth talking about your options with your current provider as well as a mortgage broker.

The amount of equity you have in your property will determine if you can remortgage. As well as how competitive the deal could be.

In many parts of the UK, house prices have increased a lot in the past 5 years. This often makes it easier to remortgage. Even if you have an interest only mortgage without saving or investing.

The average UK house price is at a new high of £245,000. 

It went up by 4.7% over the year to September 2020. Up from 3% in August 2020.¹

Do not bank on house price gains. Demand and house price rises have likely changed due to coronavirus and the stamp duty holiday.

If you already have a competitive mortgage deal, it may be hard to find a more competitive deal.

For example, if you got an interest only lifetime tracker mortgage before the credit crunch. This tracks the Bank of England’s Bank rate.

In this situation, it may be worth using the savings from your current deal to invest elsewhere. This will let you pay off the capital at the end of your mortgage.

Remember that your investment is not guaranteed to grow. You may need to look into other ways of paying off the capital at the end of the mortgage term.

Mis-sold interest only mortgages

Interest only mortgages were mis-sold as cheaper options than capital and interest mortgages. This was between 2004 and 2008. The mis-selling was due to the lower monthly payments.

There was an assumption that house prices would rise. This got worse when they fell between 2007 and 2009.

You can complain to the Financial Ombudsman if you have an interest only mortgage and feel your broker did not make it clear what you were getting into.

Commercial firms can also help you make interest only mis-selling claims.

The key factor is if your adviser was clear to you about the risks of interest only. The adviser should have told you that you'd need a payment vehicle at the end of the term. As well as not to rely on house price gains.

Tips for interest only mortgage customers

  1. Research interest only mortgages and ask your lender or broker questions if you’re not 100% sure it’s right for you

  2. Make sure you have a stable plan in place to pay off the debt at the end of the mortgage term

  3. Review your plan often to see if your investments are still enough at the end of your mortgage term

  4. Avoid relying on house prices going up, or staying at their current value to pay off your mortgage. It’s not guaranteed

  5. Contact your lender or broker if you have any problems. Or if you want to make changes to how you repay your mortgage

  6. Consider switching to a repayment mortgage or part repayment to lower how much you have to pay at the end

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Your home could be repossessed if you don't keep up repayments on your mortgage.

You may have to pay an early repayment charge to your existing lender if you remortgage.

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