Saving money on your monthly mortgage payments is tempting, especially when the cost of living and mortgage rates are rising, but is it a good idea? Esther Shaw explains what you need to know about interest-only mortgages and any potential downsides to them
Interest-only mortgages may sound appealing as they offer lower monthly payments and greater short-term flexibility compared with traditional repayment mortgages.
With this kind of arrangement, you pay only the interest accrued on your loan, but none of the capital.
At the end of the deal, the whole loan amount becomes due.
While interest-only mortgages can be a great option for some borrowers, many people are unsure how they work – or whether this type of product is a good fit for them.
In this guide, BeCleverWithYourCash will walk you through how interest-only mortgages work, who they are best suited to, and the key benefits and drawbacks.
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What is an interest-only mortgage in simple terms?
Interest-only mortgages aren’t a product type in themselves. Instead, they are a ‘payment option’ available on some home loans. As the name suggests, this option involves you only paying the interest, but not the cost of the property itself.
Here’s what you need to know:
- Monthly payments cover interest only
- The loan amount (capital) remains unchanged
- The full balance is then repaid at the end of the term
- You’ll need to show the lender what method you intend to use to repay the lump sum; this could include savings or investments – or plans to downsize or sell your home in the future
With interest-only it’s vital that you have a solid plan for repaying the mortgage’s principal amount at the end of the term.
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How does an interest-only mortgage work?
First off, you speak to a lender about this type of payment option. If you decide it’s right for you, you make monthly payments.
Note that with this type of mortgage, you only pay the interest, not the loan itself. The means repayments will be lower than those on a repayment mortgage.
What you need to know is that the original loan amount does not reduce during the term and at the end of the term, you must repay the home loan in full.
Worked example: Let’s take the example of a £200,000 mortgage at 3% interest over a 25-year term.
- With a repayment mortgage, you would repay around £950 a month, and over time, gradually pay the loan down to zero and own the property outright. In total, you would have paid almost £285,000. (This includes almost £85,000 in interest).
- By contrast, with an interest-only arrangement, you would only pay around £500 a month. The loan remains unchanged at £200,000 throughout. So, overall, you would end up having paid almost £350,000 (including roughly £150,000 in interest) – plus you still owe that huge £200,000 at the end.
Verdict: While interest-only is £450 a month cheaper, you will pay £65,000 more in interest – and you’ll be left needing to repay the full £200,000.
Word of warning: The key thing to remember with an interest-only deal is that the loan will need to be repaid back at some point. You need to plan ahead, as poor financial planning can leave you unable to repay the loan later.
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What happens at the end of an interest-only mortgage?
With an interest-only arrangement, there are a few options available to you once your loan period is up. These include:
- Selling the property and downsizing, and using the difference to pay off the loan
- Remortgaging, if you meet the affordability criteria, you could switch to a repayment mortgage either with your existing lender, or a new lender
- Finding money from savings or investments
What you can’t ignore with an interest-only deal is the fact that when it ends, the full loan remains due at once. Not having a method to repay can be financially stressful – or risky.
How do you repay an interest-only mortgage?
Here are some of the common repayment vehicles – and some of the pros and cons of each:
- Selling the property: this is a simple option which clears the loan in one clean sweep. But there’s a lot riding on property prices, and market downturns could leave you with a shortfall
- Savings: if you’re good at regularly setting money aside, this is low risk and predictable. But returns can be modest, and you might need to do some seriously long-term saving to reach your target
- Investments: with the likes of stocks or funds, there is the potential for higher returns. However, values can fall (as well as rise), so there’s no guarantee you’ll have enough at the end
- Pension lump sum: you could potentially use the tax-free cash available. But if you do, this will reduce your retirement income
- Endowment policy: this involves you using an investment-linked insurance plan designed to repay the loan. However, there’s a risk your endowment doesn’t generate sufficient returns, creating potential shortfalls
- Downsize or sell your home in the future: if you move to a smaller, cheaper home you can free up some equity. Just note that the success of this method is heavily dependent on future property prices. It will also mean a change of lifestyle, and this may not be in line with what you’d hoped for
Research carefully
Be aware that different lenders will have different rules on the repayment methods they accept. Some may accept a combination of methods to clear the balance of the loan, while others may not.
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What are the pros and cons of interest-only mortgages?
PROS
- Monthly payments will be lower than they would be with a repayment mortgage
- More affordable in the short term
- Interest-only offers more flexibility
- Potential to earn higher returns on investments while only paying interest on your mortgage; this could be used to pay off the principal later
CONS
- Capital is not repaid automatically
- Higher long-term risk
- It can feel almost like rent as you’re not paying off the capital
- You are heavily reliant on your repayment strategy
- There is the potential for negative outcomes
- There could be problems if your property value changes
What’s the difference between interest-only and repayment mortgages?
| Repayment mortgage | Interest-only mortgage | |
| Monthly repayments | Will be higher because you pay interest plus part of the loan | Will be lower as you just pay the interest |
| Loan balance | Debt reduces gradually over the term | The full loan remains unchanged throughout the term |
| What happens at the end of the term? | Will be paid off in full | A separate vehicle or plan is required to ensure the full amount is repaid |
| Level of risk | Lower because you are steadily clearing the debt | Higher risk as there’s a chance your repayment vehicle doesn’t perform as well as you’d hoped |
| Flexibility | Can offer more short-term flexibility | Provides long-term certainty and security |
| Total cost | Usually costs less overall because you reduce the balance over time – meaning you pay less interest | Often costs more overall, since you pay interest on the full loan for the entire term – and must then still repay the original amount at the end |
Which are more common?
Repayment mortgages are the more common option for most people because they allow you to steadily clear your debt and they are lower risk for both lenders and borrowers. There’s also no need to have a separate repayment strategy in place.
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Who are interest-only mortgages suitable for?
There are certain borrowers for whom an interest-only home loan makes sense. These include:
- High earners with predictable income and money in investments
- Experienced buy-to-let investors with a clear repayment strategy (property)
- Landlords using rental income to cover interest payments
- Individuals who earn large bonuses or are paid in commission
- Those with a clear repayment strategy
- Borrowers who require short-term affordability, but who plan to switch to repayment down the line
It’s also worth noting there are specific ‘retirement interest-only mortgages’ for ‘later in life’ borrowers.
With these loans, you pay the interest but will need to pass affordability checks to get one. Your home is sold to repay the loan on death or when you go into long-term care. As these loans are not as costly as equity release, there’s a better chance of having an inheritance to pass on.
I’ve written a full guide to lifetime mortgages here if you need more information.
Which borrowers should steer clear of interest-only mortgages?
Interest-only mortgages are a useful tool for some homeowners, but they’re not for everyone. If you fall into one of the below categories think very carefully before you consider taking one out:
- Those without a clear and reliable repayment plan in place (such as savings or investments)
- Those with unpredictable income
- Individuals who are close to retirement with limited time to repay the capital
- Risk-averse borrowers who are not comfortable with financial uncertainty
- First-time buyers who may not fully understand the long-term costs and risks
If you’re not sure where to start, take a look at our affordability calculator as this can give you an idea of how much you could potentially borrow. It’s also worth checking out our mortgage comparison tables where you can see the best rates in real time.
Interest-only mortgages FAQs
Can you extend or change an interest-only mortgage?
Potentially yes, but this will depend on your lender. They will assess things such as affordability and your repayment plan. Be aware they may insist on you switching to a repayment mortgage.
How much does an interest-only mortgage cost?
The exact amount you pay will depend on the rate you get (plus fees). But what you need to remember is that an interest-only arrangement typically costs less monthly than a repayment mortgage, as you only pay interest. That said, total costs can be higher overall because the loan balance never goes down.
What’s the point of an interest-only mortgage?
The main upside of this payment option is lower monthly payments. This can improve cash-flow and affordability, helping you to manage your money more easily. This can be especially helpful when your finances feel stretched.
What is the main disadvantage of having an interest- only mortgage?
The main downside of interest-only is the fact your loan balance (capital) never decreases, meaning you are left needing to repay the full amount at the end. And crucially, if your repayment plan falls short, this can be risky.
Explore your home-buying options
If you are interested in applying for an interest-only mortgage, here’s what you need to do next:
- Research providers and compare rates to see what kind of deals are available
- Try out our mortgage calculator to help you find out how much you could borrow and the monthly repayments you could expect to pay
- Check eligibility and affordability
Also be sure to seek professional advice from a mortgage broker to ensure interest-only is the right option for your needs. It’s a financial arrangement which potentially comes with risks – if you don’t have a plausible repayment strategy – so it’s vital you understand exactly what you’re getting into.
Important
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