Interest-only mortgages have much smaller monthly repayments – but the lender will only give you an interest-only mortgage if you have another way of repaying the balance at the end of the term.
What are interest-only mortgages?
As the name implies, with an interest-only mortgage you only pay back the interest on the money you borrowed. This means that by the end of the mortgage term you still owe the lender exactly the same amount that you borrowed in the first place – the loan principal – which you then have to pay off in full.
With a normal mortgage, each monthly repayment goes towards the interest and some of the principal – so by the end of the term you’ve paid off everything.
For example, if you take out an interest-only £200,000 mortgage over 25 years with an interest rate of 2.5%, your monthly repayments would be just £417. A normal repayment mortgage, over the same 25 years and 2.5% interest rate, would have monthly repayments of £897.
How to pay off an interest-only mortgage
The key to interest-only mortgages is that you must have another way of paying off the principal – and the bank or building society will want to know your repayment method before offering you an interest-only mortgage.
The simplest route is to sell the property at the end of the mortgage term and use that to pay back the lender. Many buy-to-let mortgages, where you buy a property specifically to rent it out rather than move into it, are settled in this way.
Other options are a repayment vehicle – a savings plan, a pension withdrawal, or another investment fund – or some kind of lump sum, usually via inheritance.
Which mortgage type is cheaper?
An interest-only mortgage is usually cheaper over the short term due to its lower monthly payments, but more expensive in the long run because you’re not reducing the principal.
For example, using the previous £200,000 interest-only mortgage scenario, the total amount repaid would be £325,000.
A repayment mortgage is usually more expensive in the short term as you have larger monthly repayments, but you pay the lender less money in total because each month you are reducing the principal – and thus each month you pay less and less interest. Using the previous £200,000 mortgage scenario, the total amount repaid would be £269,000.
Interest only mortgage FAQs
Can I get a part-and-part mortgage?
Yes, you can get a mortgage that is part repayment and part interest-only. You will pay off some of the loan principal each month, but there will still be an amount that must be settled at the end of the mortgage.
Can I remortgage to an interest-only mortgage?
Can I switch between repayment and interest only mortgages?
Yes, though there could be fees and other charges. Speak to your mortgage lender to find out more.