With an interest-only mortgage, your monthly payment pays only the interest charges on your loan, not any of the original capital borrowed. This means your payments will be less than on a repayment mortgage, but at the end of the term you’ll still owe the original amount you borrowed from the lender.
The difference between interest-only and repayment mortgages
There are two ways to repay your mortgage:
- Repayment
- Interest-only
With a repayment mortgage, you pay back a small part of the loan and the interest each month. Assuming you make all your payments, you’re guaranteed to pay off the whole loan at the end of the term.
With an interest-only mortgage, you only pay the interest on the loan. At the end of the term you’ll still owe the original amount you borrowed.
Payments compared
The main advantage of paying a mortgage on an interest-only basis is that your monthly payments will be much cheaper.
Let's say you borrow £200,000 on an interest-only basis, over 25 years, at an interest rate of 3%.
- If you repay the mortgage on an interest-only basis you’d pay £500 a month.
- If you repay the mortgage on an repayment basis you’d pay £948 a month.
An interest-only mortgage can make a mortgage more affordable but in this case it would mean that in 25 years’ time you’d still owe the lender £200,000. If you paid the mortgage on a repayment basis you’d owe the lender nothing and own the property outright at the end of the term.
The history of interest-only mortgages
Interest-only lending soared ahead of the 2008 financial crisis and customers were able to borrow on an interest-only basis without showing lenders how the debt would be repaid. After the credit crunch struck it emerged that hundreds of thousands of interest-only customers would struggle to pay off their home loan later on.
For this reason, it’s now very difficult to borrow on an interest-only basis. Not all lenders offer interest-only and those that do will have strict criteria such as a decent deposit and an approved repayment vehicle in place to pay off the capital at the end of the term.
The one exception is buy-to-let. Many landlords pay their mortgages on an interest-only basis and lenders generally accept this.
Either way, if you can’t repay the amount you borrow at the end of the term you’ll need to take out a new mortgage or sell the property to pay off your mortgage.
Repayment plans
Before lending money on an interest-only basis, your mortgage lender will want to see that you have an approved repayment plan in place. Acceptable repayment plans vary from lender to lender but may include ISAs and stock market investments. Your lender is likely to make periodic checks that your chosen repayment plan is on track to pay the required amount.
Previously, lenders would allow borrowers to rely on the possibility of a future windfall such as an inheritance or bonus, but very few will accept these now.
What to do if you have an interest-only mortgage
If you have an interest-only mortgage it’s important to know you’ll be able to repay the capital at the end of the term. There are several options to ensure this happens:
- Switch your mortgage to a repayment mortgage. This will mean your monthly payment will increase but your mortgage will be repaid in full at the end of the term.
- Pay into an investment plan which can be used to pay off the capital at the end of the term. A financial adviser will be able to suggest a suitable plan.
- Make lump sum overpayments or set up regular overpayments on your mortgage (if your lender allows this). Our mortgage overpayment calculator can help you work out how much you could save.
- Remortgage to a better mortgage rate, switch to a repayment mortgage and repay the loan over a longer term to make monthly payments more affordable.
If you’re worried about repaying the amount owed on an interest-only mortgage you should take action now, even if you’re several years away from the mortgage end date. The longer you leave it, the fewer options you’ll have so it’s important to seek financial advice as soon as possible.