An interest only mortgage is a type of mortgage where you only pay back the interest on the amount you’ve borrowed. You don’t start paying back the amount you’ve borrowed until the end of the term.
For some, that’s pretty handy, because it means monthly payments are much lower. But the downside is, at the end of the term, you still owe the full amount you borrowed. And before they give you an interest only deal, lenders will want to see that you’ll be able to pay that back.
So, what is an interest only mortgage? And who can have one? Here, we’ll run you through everything you need to know.
The two types of mortgage: interest only and repayment
There are two main ways that you can repay your mortgage deal.
- Repayment. These days, this is the more popular option. Get a mortgage, and every month, you repay a bit of the borrowed amount, plus interest. These can be fixed rate mortgages or variable rate deals – but, in both, you’ll be paying off the loan itself.
- Interest only. You don’t touch the borrowed amount itself, but just pay off the interest on the mortgage deal. This makes your monthly payments lower, but you end up with the same amount of debt with which you started.
And part and part mortgages? Yep, you can do a bit of both. Some lenders offer mortgages where part is interest only and part is repayment. These will differ from lender to lender, but it means you’d be left with a proportion left to repay at the end — but not the whole sum.
How to calculate your payments on an interest only mortgage
Interest only mortgages make for much cheaper monthly payments than repayment mortgages.
On a mortgage of £250,000, at 3% interest, payable over 25 years, you’ll pay £625 monthly on an interest only mortgage. With a repayment mortgage, you’d be paying £1,185 a month.
However, the total you’ll have paid over 25 years will be different. At the end of your interest only mortgage term, you still owe £250,000, while you’ll have paid £187,500 in interest.
Meanwhile, on a repayment mortgage with a stable interest rate, you’ll pay £105,800 in interest, and – if you keep up your monthly repayments – you’ll have paid off your mortgage loan entirely.
Note: If you’re looking for an interest only mortgage calculator, try our mortgage comparison tool to browse the interest only mortgages (plus costs and rates) on the market right now.
It’s worth noting that there’s another drawback to interest only mortgages, too:
Interest only mortgage deals are not for everyone
Before a lender gives you an interest-only mortgage, they’ll expect you to meet much stricter criteria than for a repayment mortgage. You’ll also have to show evidence that you’ll be able to pay back the whole loan at the end of your mortgage term.
Once upon a time, the rules were less strict and you could take out interest only mortgage deals without showing how you were going to pay them back. When banks realised there were too many cases where they wouldn’t see the funds again, the rules changed quickly.
So these days, it’s pretty hard to get an interest only mortgage. For residential borrowers, interest only mortgage providers are few and far between. According to Moneyfacts, only 3% of mortgage deals are interest only. And if you want one, you’ll need to meet strict criteria:
Interest only mortgage criteria
- A mortgage repayment plan. If you get an interest only mortgage deal, you’ll need to prove you’ll be able to pay it off. Lenders will want to see your mortgage repayment plan – in other words, your strategy for paying off the mortgage loan. For example, this could be evidence of investments, or a pension or savings plan.
- A chunky deposit. Some lenders want half of the value of the property in a deposit. Others, even more.
- Serious earnings. Some mortgage providers want to see evidence of a personal income of over £75,000, say – or a household income of over £100,000 – if you want an interest only mortgage.
- A good credit score. On top of that, you’ll need to prove that you have a solid credit score, too.
All this means that the vast majority of first time buyers won’t be eligible for an interest only mortgage.
Any exceptions? Who can get an interest only mortgage?
There are two main interest only mortgages that don’t have these criteria:
- Interest only buy to let (BTL) mortgage. If you’re buying a house to rent it out, you can still get an interest only mortgage. In fact, buy to let mortgages are usually interest only.
That’s because BTL mortgages are technically commercial loans, not consumer loans – and most standard BTL mortgages aren’t regulated by the Financial Conduct Authority. As a result, lenders have greater freedom over who they can lend to.
- Retirement interest only mortgage, or RIO. This is an interest only mortgage which is designed for pensioners. Usually, you only need to prove that you can afford the monthly repayments, not the whole sum, because you will repay the loan when your home is sold after you pass away, move into care, or move to a different property.
What do I need to know if I have an interest only mortgage?
First up, unless you’re on a RIO mortgage, interest only deals can be a little risky. As you’ll only be paying off the interest, there’ll be a big lump sum to pay off at the end of the term – on top of the interest you’ve already paid.
That means you should be saving or investing enough to be able to pay it back. The risk is, of course, that your circumstances can change – and you can never guarantee you’ll be able to repay when the time comes.
What if I can’t pay off my interest only mortgage?
Good question. Technically speaking, your interest only mortgage contract will entitle lenders to repossess your property if you can’t pay off your mortgage.
However, it’s not all so scary. You do have some options if it looks like you’ll struggle to pay it off.
- Remortgage. In some cases, you could pay less interest by remortgaging the property and finding a different interest only mortgage deal with a new lender. Like many remortgages, this means going through the mortgage application process again.
- Change to a repayment mortgage (or part and part). This will mean remortgaging again. But, if you can’t pay the full sum but want to keep the property, you may be able to switch to a repayment mortgage. You’ll probably have to pay a bit more in the short-term (as repayment mortgages generally want higher monthly payments). However, this way, you can repay what you’ve borrowed without needing to cough up the whole sum at once.
- Sell your property. If you don’t have the cash to pay off your mortgage, you could sell up. This might release some equity (extra value from your property) which you could use to buy a new place, for example.
- Extend your interest only mortgage term. You’ll have to ask your lender if they’ll let you do this. Though all this will do is buy you some time – you’ll still eventually need to pay off the loan.
If you need a hand with anything related to your mortgage, Habito is here to help. As a broker, we’ll help you find the right mortgage and guide you through the whole process.