An interest-only mortgage is a home loan where your monthly mortgage payments only cover the interest you are being charged on the total amount you have borrowed (the capital); this differs from a repayment mortgage, in which your monthly mortgage payments are calculated to cover both the loan interest, and repayment of the amount borrowed over the agreed repayment term. Repayment mortgages are sometimes referred to as “capital and interest” mortgages, to differentiate them from interest-only mortgages.
With an interest-only mortgage, as you are not repaying any of the mortgage debt itself, the monthly interest-only repayments can be significantly lower than they would be for a repayment mortgage of the same amount. However, you will need to have a plan – sometimes referred to as a “repayment vehicle” – in place to repay the total balance of the mortgage on or before the end of your repayment term.
Examples of repayment vehicles can include endowment policies, pensions, ISAs or the sale of the property itself. Lenders who offer interest-only mortgage products will each have their own policies on what types of plans and investments they are willing to accept as repayment vehicles. Cash in a savings account, for example, may not be acceptable to some lenders as a repayment vehicle for an interest-only mortgage.
Difference in payments between an Interest Only and a Repayment Mortgage?
Interest-only mortgages have the benefit of lower monthly payments than on a repayment mortgage of the same amount; that is because the payment only covers the interest, and does not repay any of the mortgage capital over the term. However, because the balance is not reducing, the total interest charged over the life of the mortgage is more than on an equivalent repayment mortgage.
Who might be suited to an Interest Only mortgage?
Interest-only as a mortgage repayment method can be suitable for all types of borrowers, from first-time buyers and home movers, to buy-to-let investors and those looking to remortgage. An interest-only mortgage is not right for everyone – and some lenders do not offer interest-only mortgages at all – however, this type of mortgage can be advantageous for many reasons when individual borrowing needs and personal circumstances are taken into consideration.
In areas where house prices are high, such as in London and the South-East, buying a property with an interest-only mortgage can be seen by some as a cheaper option than renting a property. There is also the view of certain home buyers that, while you may not be paying off the actual capital of the loan, you are on the property ladder and you do own your own home.
Many buy-to-let investors use interest-only mortgages because it enables them to keep their monthly mortgage commitment to a minimum – thereby maximising their monthly rental yield – whilst opting to make lump-sum part repayments towards the mortgage capital at periods throughout the loan if required. An interest-only mortgage can also reduce the monthly cost of property ownership if the investor is looking primarily for capital growth rather than longer-term income.
The benefits of interest-only mortgages can also apply to the self-employed, contractors, freelancers, and others who may have irregular monthly income. In this case, the lower monthly interest-only repayments can help when budgeting.