What is an interest-only mortgage?

What is an interest-only mortgage?

author: Bryony Pearce

By Bryony Pearce

An interest-only mortgage is pretty much what it says on the tin – you only pay the interest.

With standard mortgages, your monthly repayments will include both your interest and mortgage capital – your mortgage capital is the amount you’ve borrowed from the lender.

By the end of a repayment mortgage, you will have repaid all of the mortgage’s capital and paid the interest, meaning you own your home outright.

With an interest-only mortgage, your monthly repayments are made up only of the interest attached to your mortgage. This means that you will still owe the entire mortgage capital at the end your agreed term.

To explore the pros and cons of interest-only mortgages, head over to our blog post on it here.

Family at home

The maths

For the purpose of this example, let’s imagine you’ve taken out a £100,000 mortgage, over a 25-year term, with an annual interest rate of 5%.

Your monthly repayments would amount to just under £417 and this payment would remain the same for the entire term. By the end of the 25-year term, you will have paid £125,000 in interest.

But because the £125,000 you will have paid only covers the interest on the loan, you will still owe the full £100,000 you borrowed – the mortgage capital – at the end.

On the other hand, if you took out a repayment mortgage for £100,000 over 25 years and with an interest rate of 5%, you’ll pay around £585 a month. By the end of the 25 years, (assuming you never missed a payment) you’ll have paid £175,441 (the capital plus the interest) and the property will be yours.


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

Before you take out an interest-only mortgage, you must be able to show the lender you’ll be capable of repaying the mortgage capital at the end of the term. How you do this is up to you.

Savings, stocks and shares ISAs, pensions, investment bonds, shares, unit trusts, regular savings plans and other assets are a few ways borrowers repay their mortgage capital. Ask yourself how using these will affect your income – particularly if you think you’ll have retired by the time your mortgage term ends.

"You must tell your lender how you plan to repay your capital when you apply."

You will have to tell your lender how you plan to repay your capital before they accept your interest-only mortgage application. Once you have informed them of your plan, they will make a decision as to whether they think your proposal is likely to pay off the capital sum.

If they don’t have confidence in your proposal or think you present too great a risk, your application may be turned down.

New home

What if I can’t afford to repay my mortgage?

If you have an interest-only mortgage and you don’t think you’ll afford to repay the capital at the end of the term, don’t sit on it. The sooner you act, the more options you will have.

If you don’t take any action, you run the risk of your home being sold or repossessed.

There are two common misconceptions of how people think this can be resolved:

  • Remortgage at the end of your term – there are three main problems with this. Firstly, you’d need a hefty salary and a lot of equity in the property. Secondly, most people are well into their 50s by the time their term ends, and unless you have a very healthy pension you might not meet the new mortgage affordability criteria. Thirdly, you may find it difficult to find a remortgage deal if you have a lot of unsecured debt.
  • Continue payments – by taking out an interest-only mortgage you will have signed a legal agreement to repay the capital in full at the end of the term. The lender is under no obligation to allow you to continue making monthly repayments until the capital is paid off too.

One legitimate option could be to switch to a repayment mortgage with the lender who provided your interest-only mortgage. Bear in mind though, your monthly payment would go up as a result. This is because you would be repaying both the interest and capital.

If you’re on an interest-only mortgage and are in any doubt about financing your outstanding mortgage capital in full, you should contact your lender as soon as possible to discuss the options available to you.

Disclaimer: All information and links are correct at the time of publishing.

author: Bryony Pearce

By Bryony Pearce