Interest-Only Mortgages Explained

What is an interest-only mortgage?

With an interest-only mortgage, you only pay the interest that’s due on your mortgage loan each month. As you don’t repay any of the loan, this means that your monthly payments are considerably lower than those for a repayment mortgage. However, as you’re only making the interest payments, the full amount that you borrowed for your loan remains the same throughout your mortgage term. This usually has to be repaid in a lump sum at the end of the term so you need to plan how you’re going to do this before you take out the mortgage.

As lenders are concerned that having to repay the full amount may cause issues for borrowers in the future, interest-only mortgages aren’t as common as repayment mortgages. To avoid a situation where you might find yourself unable to repay the loan at the end of the term, your lender will ask you to provide a repayment plan. For example, you may have savings and investments that you can use or you may choose to sell the property and repay the loan from the proceeds.

You should be aware that having an interest-only mortgage costs you more in the long run. As you’re not repaying any of the capital, the interest is charged on the full loan amount each month. This is in contrast with a repayment mortgage when interest is charged on a decreasing amount each month. Over the entire mortgage term, paying interest every month on the entire loan can add up to a considerable amount. So while it’s a cheaper monthly option for you that can ease your living expenses, it’s an expensive option to choose in the long term, costing you a lot more overall.

How do interest-only and repayment mortgages differ?

Your mortgage is comprised of the capital, which is the amount you borrow, as well as the interest charged on that loan by the lender. You have two options when it comes to the monthly payments of your mortgage — repayment or interest-only.

A repayment mortgage

When you opt for a repayment mortgage, which is also known as a capital repayment mortgage, you repay some of the capital each month as well as the interest charged on it. As you’re paying both of these amounts, your monthly payments are much higher than opting for an interest-only mortgage. However, doing it this way means that you will have repaid your loan by the end of your mortgage term. This can be 25 years, for example. At that point, you will own your property outright.

Also, the interest charged each month is calculated on the outstanding loan amount, which gradually decreases throughout the term. Repayment mortgages are much more common than interest-only mortgages as they have a lower level of risk.

An interest-only mortgage

When you choose an interest-only mortgage, only the interest on the loan is paid each month. This makes your monthly mortgage payments much cheaper than if you had a repayment mortgage. As mentioned earlier, however, none of the loan is repaid. For example, you decide to buy a property in Pimlico for £400,000 using an interest-only mortgage. The interest-only basis makes your monthly payments much more affordable compared with a repayment basis. In 10 years’ time, however, you’ll still owe £400,000 for your property. As the balance of your mortgage loan stays the same throughout the mortgage term, you’re also more at risk of negative equity should the market turn. Interest-only mortgages also usually have higher interest rates than repayment mortgages.

An interest-only mortgage presents you with two main drawbacks. The first is that the interest is charged on the full loan amount each month, making your overall mortgage much more expensive. The second is that you have to repay the full loan amount at the end of the term. You need to provide your lender with proof of how you’re going to do this. Due to the level of risk involved, interest-only mortgages aren’t as common for residential properties as repayment mortgages are. They are, however, frequently offered for buy-to-let properties or to borrowers who want to take out a mortgage later in life. This is because lenders know that buy-to-let properties can be sold to repay the loans and retirement mortgages can be repaid when the borrowers either go into long-term care or pass away.

Eligibility for an interest-only mortgage

Whilst each lender has different criteria for residential interest-only mortgages, you’re more likely to be approved for one if:

• You have a substantial deposit, such as 25%. Some lenders may insist on a higher amount, such as 40% or 50%.
• You earn a high income. Some lenders set a minimum annual income requirement before agreeing to a residential interest-only mortgage. For example, you may need to earn a minimum of £75,000 per year or have a combined annual income of £100,000 if making a joint application. Other lenders only consider high net worth individuals for this type of mortgage.
• Your repayment plan is solid and agreed upon by the lender.
• The property you’re buying has a standard construction. This is because a property with a non-standard construction, such as one with a timber frame, poses more of a risk to lenders.

Lenders usually have minimum and maximum age thresholds with the exception of specific interest-only mortgages that are required later in life. When applying for an interest-only mortgage for investment purposes, there are different criteria to adhere to. For example, lenders usually prefer you to have experience as a landlord.

How much can you borrow with an interest-only mortgage?

Lenders generally offer a loan-to-value (LTV) ratio of up to 75% for interest-only mortgages. This means that you’d need a 25% deposit. As mentioned above, each lender has different requirements so you may need to pay a higher deposit amount. The amount you can borrow also depends on other factors. These can include how much you want to borrow, your affordability for the loan and the purpose of the loan. For example, whether you intend to buy a residential property or a buy-to-let investment property.

Get expert advice on interest-only mortgages

Our mortgage brokers – located throughout Kent, London and Edinburgh – are ready to answer any queries you may have about interest-only mortgages. They can explain the differences between interest-only and repayment mortgages and check your circumstances to find out which type is more suitable for you. If you prefer an interest-only option, they’ll check that you meet the strict lending criteria. When you’re ready to proceed, your application will be tailored to maximise your borrowing potential and then presented to the most suitable interest-only mortgage lender. Just give us a call on 01322 907 000 to get started.

As we, at Trinity Finance, have unrestricted access to lenders, you can rest assured that you’ll receive details of the latest deals available, including those only offered by lenders via brokers. If you’re unable to contact us by telephone, simply send an email to us at info@trinityfinance.co.uk. Alternatively, send an enquiry to us via our contact form. One of our mortgage brokers will reply to you as quickly as possible with more information about interest-only mortgages.

A repayment plan for your interest-only mortgage

Interest-only mortgages were popular before the 2008 financial crash. Borrowers benefitted from cheaper payments without having to provide proof of how they intended to repay the loan at the end of the term. Since then, however, many lenders have withdrawn interest-only mortgages for residential properties because of the risk involved. Whilst interest-only mortgages are regularly provided for buy-to-let properties, they are not as common for residential properties. The lending criteria for a residential property are also much stricter. One aspect that has to be adhered to for an interest-only mortgage is having a repayment plan. This must be a solid plan that meets your lender’s approval.

When taking out a buy-to-let mortgage, it’s usually acceptable to sell the property as your repayment strategy. For a retirement interest-only mortgage, lenders understand that the loan will be repaid when you either sell your property, move into a care home on a long-term basis or pass away. With a residential interest-only mortgage, some lenders may agree to you selling the property but only if there is a minimum amount of equity. There are other, more preferable options that lenders consider suitable for a repayment plan. These can include:

• A pension plan
• Savings
• A stocks and shares ISA
• Investment bonds
• Unit trusts
• An endowment policy
• Selling a different property
• Selling other assets, such as vehicles, jewellery or artwork
• Equity release
• A remortgage
• Making regular overpayments

It’s important to understand that your lender will occasionally check that your repayment plan is still on track.

What happens at the end of the interest-only mortgage term?

The outstanding loan balance needs to be repaid at the end of the term. This is usually done in a lump sum as per your repayment plan. Your lender will more than likely remind you that your mortgage term is coming to an end. For example, they may contact you 12 months before the end of the term and again 6 months before it’s due to end.

What happens if you can’t repay the loan at the end of the term?

If you’re unable to repay the interest-only mortgage loan when the term comes to an end, there are some options to consider, as detailed below.

• Extend the mortgage term. This gives you a bit more time to repay the outstanding balance.
• Remortgage to a cheaper deal. You may be able to secure a new deal with your existing lender that gives you a better rate. Alternatively, you may find a better deal with a new lender.
• Switch to a repayment mortgage. A repayment mortgage means that you’ll gradually pay off your loan. Just bear in mind that your monthly payments will be higher as you’ll be paying both the capital and the interest that’s due.
• Switch to a retirement interest-only mortgage. Depending on your age, you may be able to switch to a retirement interest-only mortgage. This type of mortgage doesn’t have an end date. Instead, the loan is repaid when you either sell your home, move into a care home for the long term or pass away.
• Sell the property. You may have no choice but to sell the property. If its value has increased since you took out the mortgage, you can put the extra funds towards buying a new home. If, however, the value has fallen and you’ve gone into negative equity, your other assets may be at risk.

If you’re worried that there’s an issue with your repayment plan, call our mortgage brokers on 01322 907 000. They’ll take a look at your mortgage arrangement and talk through the available options with you. It’s better to contact us sooner rather than later so that we can help you to put a contingency plan in place as early as possible.

The advantages of an interest-only mortgage

There are various advantages to having an interest-only mortgage:

• You make lower monthly payments than with a repayment mortgage, which helps with your cash flow.
• With the savings you make by choosing an interest-only option, you can use the money to make improvements to your property, which may increase its value.
• Without having to prove your affordability for higher monthly payments, which you’d have to do with a repayment mortgage, you may be able to afford a better property.
• If you’re a buy-to-let landlord, you can save any rental profit you make and use it to repay some of the mortgage loan at the end of the term.
• Lenders usually allow you to make overpayments, helping to reduce the overall amount owed.
• When your circumstances change and you can afford to make higher payments, you can switch to a repayment mortgage. At that point, you’ll start reducing the balance of the mortgage loan.

The disadvantages of an interest-only mortgage

There are also some disadvantages to consider before opting for an interest-only mortgage:

• The lending criteria for a residential interest-only mortgage are much stricter than for a repayment mortgage.
• You’ll pay more for your mortgage overall as the interest is calculated on the full loan amount each month.
• You have to repay the entire mortgage loan at the end of the term.
• You won’t own your property outright until the mortgage loan has been repaid.
• If something goes wrong with your repayment plan, you may not have enough to repay the loan when it’s due. In this case, you may not have any choice but to sell your property. If your property’s value has decreased and isn’t enough to repay the loan, you risk losing your other assets too.

Alternatives to interest-only mortgages

If you’re not sure whether an interest-only mortgage is right for you, there are a couple of alternatives to consider — a repayment mortgage and a part and part mortgage. As previously mentioned, you repay some of the capital each month as well as the interest with a repayment mortgage. As your mortgage loan balance gradually decreases, the amount of interest charged also begins to decrease. When your mortgage term ends, you’ll have repaid your loan and own your property outright. This type of mortgage is more commonly offered by lenders.

A part and part mortgage is a combination of both interest-only and repayment mortgages. You repay some of the capital each month but not as much as you would with a repayment mortgage. This keeps your monthly repayments lower than having a repayment mortgage but higher than an interest-only mortgage. The amount that the interest is calculated on each month also gradually decreases. As you’re paying off some of the mortgage balance, there’s not as much to repay at the end of the term. As there will still be an outstanding loan amount at the end of the mortgage term, however, you still need to have a repayment plan in place.

Benefit from lower payments with an interest-only mortgage

Get in touch with our mortgage brokers on 01322 907 000 to discuss all of the options available to you. If you’re ready to apply for an interest-only mortgage and your circumstances meet the requirements, your application will be tailored accordingly. With mortgage brokers located throughout Kent, London and Edinburgh, we can help you to secure an interest-only mortgage for residential, offset, buy-to-let or retirement purposes.

At Trinity Finance, we work closely with lenders offering interest-only mortgages and will compare your circumstances to the various lending criteria. We will approach the best-matched lender on your behalf and negotiate for the most flexible terms and competitive interest rate. We can also help with other aspects related to buying a property, such as arranging your insurance and putting mortgage payment protection in place. For more details on the range of financial services we offer, send an email to us at info@trinityfinance.co.uk or an enquiry via our contact form.