In a conventional mortgage, each month you repay a small amount of interest and a small amount of the money you borrowed.
Interest-only mortgages mean your monthly mortgage payment is only covering the interest of the mortgage. The monthly instalments are smaller, but you are not paying any money off the mortgage itself.
This means that monthly repayments on an interest-only mortgage are much lower than with a traditional repayment mortgage.
Instead, the capital you borrowed is paid back at the end of the mortgage term.
For this reason, if you apply for an interest-only mortgage, you will need to show your lender that you have a plan for how to pay off your debt in full when you have finished paying off the interest.
This plan, called a repayment vehicle, may include investments, ISA savings or other property.
Interest-Only Mortgage: How Are They Different?
In a traditional repayment mortgage, every month you pay back a portion of the amount you borrowed plus interest. At the end of the mortgage term, you will have paid off the full amount you borrowed from the bank plus all of the interest accrued on that money.
With an interest-only mortgage, you only pay back the interest on the money you borrowed, but you don’t start to pay back the capital itself for a long time.
After an introductory period, usually between 7-10 years, your monthly mortgage payment increases and you start to make contributions towards the capital you borrowed as well as paying the interest.
Even so, monthly repayments on an interest-only mortgage are usually much lower than a repayment-style mortgage throughout the term of the loan.
At the end of the mortgage, you are expected to use savings or other investments to repay the full amount you borrowed.
Can I Get an Interest-Only Mortgage?
There are strict criteria which you need to meet if you would like to take out an interest-only mortgage. These are in place to make sure that you can afford to make mortgage repayments and repay your capital in full at the end of the mortgage.
Interest-Only Mortgage: Solid Repayment Strategy
You will need to present a solid repayment strategy to cover the lump-sum due at the end of the mortgage.
This could be in the form of an ISA, investments or other property which have enough value to cover the amount you borrowed.
Interest-Only Mortgage: Good Credit Score
If you have a good credit score, you are more likely to be accepted for an interest-only mortgage. It is considered a risky investment for lenders, so proof that you have a history of making repayments on time will help to reassure your provider.
Interest-Only Mortgage: High, Reliable Income
Some people struggle with repayments when they increase at the end of the introductory period. For this reason, it is helpful if you can provide evidence that your salary is substantial enough to cover the planned increase in repayments as well as the lower introductory rate.
The higher rate after the introductory period is often not very competitive and may not be fixed. This makes interest-only mortgages more suitable for high earners.
Interest-Only Mortgage: Large Deposit
Interest-only mortgages normally require borrowers to offer a higher-than-usual deposit. This is normally around 25%, but in some cases lenders may ask that you cover 35% of the property as a deposit.
Interest-Only Mortgage: What Are Suitable Repayment Strategies?
Before you approach a lender, you will need to think about how you plan to make your repayment at the end of the mortgage term. This will depend on your personal circumstances. In all cases, you will need to present evidence to your provider that your strategy is bona fide. You may need to find a consultant who can independently assess your investment vehicle before agreeing on the terms of the mortgage.
After you have both agreed on a strategy and you have borrowed the capital, the provider is allowed to regularly on your investments to ensure that your savings, second property, or whatever assets you plan to use are still in place.
Every provider will have slightly different requirements for investment vehicles and a model which is acceptable to one lender may not be acceptable to another.
However, the following strategies are ones which are commonly accepted in the UK:
Mortgage Repayment Strategy: ISA or Savings
If you have built up a savings account, this may be accepted as a repayment strategy. Before approaching your lender, you should prepare evidence of your current savings and how you plan to continue making payments to cover the cost of the mortgage.
Mortgage Repayment Strategy: Stocks and Shares & Bonds
Stocks and shares could be acceptable, however you may need to seek a third opinion to assess the projected value of your investments for the mortgage provider.
Mortgage Repayment Strategy: Pension Lump Sum
When you retire, you can withdraw up to 25% of your pension pot in cash, tax-free. If the end of your mortgage term coincides with your retirement, you could consider using this lump sum to pay off your mortgage. However, you should remember that if you withdraw the lump sum, the remaining 75% – all of your subsequent pension withdrawals- will be taxed.
Mortgage Repayment Strategy: Equity Release
If you will be over 55 years old at the end of your mortgage term, you may be able to release equity on your home or investment properties to pay off your mortgage.
You can find out more about Equity Release at our partner site Equity-Tree.
Mortgage Repayment Strategy: Selling the Mortgaged Property
Downsizing at the end of the mortgage term could be a way to raise the capital you owe. If this is your only property, your lender is likely to attach additional conditions to this kind of repayment strategy to account for the risk of possible depreciation in house prices.
Mortgage Repayment Strategy: Selling a Second Property
If the property you are mortgaging is not your main residence- for example, if you have taken out a buy-to-let mortgage- you could plan raise the funds by selling the mortgaged property at the end of the term.
Interest-Only Mortgages: Can I Repay Early?
Yes, in most cases providers will allow you to repay your interest-only mortgage early. However, there are normally early repayment fees for doing so.
How Much Do I Need for an Interest-Only Deposit?
Most providers will ask you for a larger deposit than you would pay for a standard repayment mortgage. Normally, this will fall somewhere between 25-40% of the property value.
However, of the property has any unusual construction details (e.g. historical buildings), the lender may consider these a risk to their investment and could ask you to offer an even larger deposit.
Interest-Only Mortgages: How Much Can I Borrow?
The amount you can borrow on an interest-only mortgages is usually capped at four times your salary or the projected eventual value of the investment vehicle (whichever is greater).
In exceptional circumstances, a lender is permitted to offer up to six times your salary.
Can I Mix and Match?
Some providers offer ‘part and part’ mortgages, which are a middle-ground between repayment and interest-only agreements. You pay back a portion of the capital, but not as much as you would ina pure repayment mortgage. This means that your monthly repayments are relatively low, but you still have some capital to pay back at the end of the term.
These are suited to people whose investment vehicle doesn’t completely cover the cost of their capital, but who would still to reduce their monthly payments. Part and part mortgages are tailored to individual circumstances; so you would need to propose your investment strategy to the provider and negotiate a repayment plan together.
What Happens if I Can’t Repay My Mortgage?
Financial uncertainty towards the end of the mortgage term is one of the major drawbacks of an interest-only mortgage. However, there are several options available which can help ensure you keep your home even if your repayment strategy does not make the returns you were expecting.
Most lenders will be able to work with you to remortgage your property if you find you are struggling to make repayments. This may take one of two forms: the lender could offer an extension on the term of the mortgage. In this scenario, you would delay the final repayment and continue making monthly repayments on the interest in the meantime.
Alternatively, if you can afford to increase your monthly payments but don’t have enough to repay your lump-sum capital, you could switch to a repayment mortgage. This would help you start to pay off the money you borrowed in your monthly repayments.
If you are over 55 years old and facing a shortfall in your investments, you might consider equity release or a retirement investment-only mortgage as a way to source capital.
How Can The Mortgage Bank Help?
Here at The Mortgage Bank, we have partnered with some of the UK’s leading mortgage brokers.
They have already helped thousands of people get the best remortgage deal even people that have been refused before, and they can do the same for you.
Choosing an independent adviser means they won’t recommend a scheme unless they are sure it is in your best interests. Their advice is also regulated by the FCA, which gives you an additional layer of protection.
If you would like to speak to one of these brokers who can provide you with a ‘whole market quote’ then click on the below and answer the very simple questions.