What is an interest-only mortgage?
An interest-only mortgage is a loan for a property that allows you to pay off just the interest on your borrowing each month, and not the capital.
This means your monthly payments don’t pay off any of the loan - instead, you pay the full amount back at the end of the mortgage term in one lump sum.
Which? Mortgage Advisers can explain how they work and recommend the best deal for you.
How interest-only mortgages work
With an interest-only mortgage, the size of your debt stays the same throughout the mortgage term.
This is different from a repayment mortgage, where you pay back both interest and capital each month. This allows you to chip away at your debt so by the end of the term you've fully repaid the original sum borrowed.
On a £250,000 interest-only mortgage charging 3% over 25 years, you'd repay £625 a month, equating to £187,500 over the 25 years, but would also have to pay back £250,000 at the end of the deal.
If you borrowed £250,000 on a repayment mortgage with the same terms, you'd repay £1,186 a month and would have cleared the capital after 25 years. Under these terms, you'd pay £105,800 in interest - making it £81,700 cheaper than the interest-only mortgage.
- Find out more: repayment mortgages explained
Who offers interest-only mortgages?
Moneyfacts data shows that, before the 2008 financial crash, there were 73 lenders in the market willing to lend on an interest-only basis.
In the wake of the credit crunch, the deals dried up as many lenders withdrew their deals. By June 2013 there were just 12 lenders willing to offer interest-only mortgages.
However, increasing numbers of lenders are returning to interest-only lending, albeit with much stricter lending criteria on loan-to-value ratios and salary requirements.
Currently, there are 18 lenders offering interest-only mortgages including Post Office Money, Leeds Building Society and HSBC.
Is an interest-only mortgage right for you?
With an interest-only mortgage, your monthly repayments will be lower but your repayments won’t help you reduce your debt.
This makes interest-only mortgages risky, as they require borrowers to save or invest enough during the course of their mortgage term to be able to pay off the full amount at the end.
For this reason, interest-only deals are only really suitable for those that have a lot of equity and have a repayment plan to pay the capital lump sum back.
- For free advice on whether an interest-only mortgage could be right for you, call Which? Mortgage Advisers on 0800 197 8461.
Who can get an interest-only mortgage?
You can get an interest-only mortgage on a residential or buy-to-let basis; however, the lending criteria might mean this isn’t a viable option for you if you're a first-time buyer.
Residential interest-only mortgages have strict lending criteria. Typically lenders will only allow you to borrow up to 50% of the property value, so you will need to have a large deposit or equity in your home to make up the rest.
Some lenders will also only lend on an interest-only basis to high-net-worth individuals with incomes of £100,000 or more.
So a residential interest-only deal probably isn’t the best mortgage for a first-time buyer, but could potentially be an option for wealthy individuals with a big deposit or existing homeowners with a lot of equity looking to remortgage.
The rules on buy-to-let interest-only mortgages are less strict. That’s because interest-only borrowing is standard for these types of purchases as landlords will be earning rental income and be treating the property they buy as an investment, rather than their home.
- Find out more: buy-to-let mortgages
How to apply for an interest-only mortgage
You can apply for an interest-only mortgage direct through a lender or through a mortgage broker.
Often, the best interest-only mortgage deals are only available through brokers.
That’s because some lenders, such as Kent Reliance Building Society and Santander, only offer their interest-only deals through ‘intermediaries’, which means you have to apply through a mortgage broker to get the mortgage.
Which? Mortgage Advisers will compare all available deals - including both intermediary-only mortgages and also those you can only get by applying direct - before making a recommendation on the best deal for you.
- Call them free on 0800 197 8461 and check which offers you’re eligible for.
Repayment plans for interest-only mortgages
Lenders will want to know how you plan to pay off an interest-only mortgage before agreeing to lend you any money on this basis.
Acceptable repayment strategies for many residential interest-only mortgages include a savings plan, an investment portfolio, a pension or other assets you plan to sell.
Capital growth, where you count on the value of your property rising over the term of the mortgage, is not usually an acceptable strategy on a residential interest-only mortgage but can be used on buy-to-let interest-only mortgage deals.
Interest-only mortgage mis-selling
UK Finance estimates that there are 1.7m outstanding interest-only mortgages in the UK, and many borrowers are believed to have taken them out without fully understanding how they worked.
If you think you were mis-sold an interest-only mortgage - for example, if the mortgage broker did not explain that you would only pay interest on your loan each month, or ask how you would repay the mortgage at the end of the term, you can use our template letter to make a complaint.
Under the conditions of your mortgage, lenders will have the legal right to repossess your home if a loan has not been repaid by the end of the term.
The good news is that, if you’re coming to the end of an interest-only deal and are worried about not being able to pay it off, you do have options.
1. Switch to a repayment mortgage: your lender might let you do this - but bear in mind that it would cause your monthly payments to shoot up in the short term. However, you may be able to reduce the payments by lengthening the term of your mortgage or opting for a part-interest-only, part-repayment deal.
2. Extend your mortgage term: if you can’t afford the steeper monthly payments that a repayment mortgage would incur, even if you extended the term, you could ask whether you can extend the term of your interest-only deal. This would buy you extra time to invest money or for your property's value to grow in order to cover the shortfall if you were to sell.
3. Remortgage: you may be able to cut interest costs by moving to a more competitive interest-only deal. However, this is unlikely to be an option if you're in negative equity, and you'd also need to go through a standard mortgage application process which might not be ideal depending on your circumstances,
4. Overpay your mortgage: paying off more than the interest each month can help you to start reducing your debt. Most lenders will allow you to overpay by up to 10% of the outstanding mortgage per year before incurring penalties, but check the terms of your agreement to be sure.
5. Use some of your pension: you can withdraw up to 25% of your pension as a tax-free lump sum - but do factor in the impact this will have on your retirement income before making any decisions.
5. Sell up: if your property value is the same as or more than the sum you bought it for, you could pay back your loan by selling your property. If the value has grown a lot and so you've built up a decent chunk of equity, you could use this to buy a different home.
However, this might not be a great option if you have negative equity – where the value of your property has fallen since you took out the loan – as you'll face a shortfall when paying your lender back.
- The options can seem complex and overwhelming - so we'd recommend getting an expert opinion from an IFA or mortgage adviser before deciding what to do.
Get expert advice on your options
Whether you're interested in taking out an interest-only mortgage or are coming to the end of your term and want advice on how to pay the loan off, you can talk to Which? Mortgage Advisers for free. They can give impartial, expert advice and recommend the best option based on your personal circumstances.
Call them on 0800 197 8461 or fill in the form below for a free call back.