Interest Only Mortgage Explained

When exploring mortgage products in the UK, one of the common options available to homebuyers and investors is the interest only mortgage. While it can be a useful financial tool for some, it’s important to understand how it works, the potential advantages, and the associated risks before deciding whether it suits your needs. This detailed guide explains everything you need to know about interest only mortgages.

What Is an Interest Only Mortgage?

An interest only mortgage is a type of mortgage where your monthly repayments only cover the interest on the loan, rather than reducing the capital. This means that throughout the mortgage term, you are not repaying any of the original amount borrowed. At the end of the term, the full mortgage balance is still outstanding and must be repaid in a lump sum.

This differs from a repayment mortgage, where each monthly payment covers both interest and part of the capital, gradually reducing the balance over time.

How Does an Interest Only Mortgage Work?

With an interest only mortgage, you make monthly payments that cover only the interest charged by your lender. For example, if you borrow £200,000 at an interest rate of 3% per annum, your monthly payments would be roughly £500. This payment remains constant throughout the term, assuming the interest rate doesn’t change and the mortgage is on a fixed-rate deal.

Since you’re not paying off the capital, the full loan amount must be repaid by the end of the mortgage term. Usually, borrowers are required to have a separate repayment plan in place, such as savings, investments, or the sale of the property to cover this final repayment.

Who Typically Uses Interest Only Mortgages?

Interest only mortgages are often used by:

Buy-to-let investors aiming to maximise rental yield and capital growth
High-net-worth individuals with complex financial arrangements
Homeowners expecting to receive significant future wealth, such as inheritance
People with a strong investment strategy in place to repay the loan at the end of the term

These mortgages may be more suitable for borrowers with the financial discipline to manage a long-term repayment plan and who understand the implications of not reducing the capital over time.

Eligibility Criteria for Interest Only Mortgages

Due to the risks associated with interest only mortgages, lenders have tightened criteria over the years. To be eligible, you may need to:

Provide a robust and credible repayment strategy
Have a higher income or equity stake in the property
Have a larger deposit, often 25% or more of the property’s value
Demonstrate financial stability and a strong credit history

Lenders will assess your repayment plan in great detail. Plans might include investments like ISAs, stocks and shares portfolios, pensions (though not all types of pensions may be accepted), or property downsizing plans.

Types of Repayment Strategies

An acceptable repayment vehicle is a critical component of an interest only mortgage. Common strategies include:

Investment Plans: Stocks and shares ISAs, unit trusts, or other managed investment portfolios.
Pensions: Using tax-free pension lump sums to repay the capital.
Downsizing: Selling the mortgaged property and moving to a cheaper home at the end of the term.
Other Properties: Selling another property or asset with sufficient value to repay the mortgage.

Lenders may review the projected performance of your chosen repayment strategy regularly during the mortgage term to ensure it remains viable.

Pros of Interest Only Mortgages

Interest only mortgages can offer several potential advantages:

Lower Monthly Payments: Since you’re only paying interest, initial monthly costs are significantly lower than a repayment mortgage of the same size.
Increased Cash Flow: Lower payments may leave more disposable income for other uses including investment, home improvements, or personal expenses.
Flexibility: Some borrowers can benefit from being able to switch to a repayment mortgage later, or overpay to reduce the capital when they choose.
Investment Opportunities: When used by experienced investors, the reduced outgoings can be reinvested elsewhere for potentially higher returns.

Cons and Risks of Interest Only Mortgages

Despite the potential advantages, interest only mortgages are not suitable for everyone and carry several risks:

Full Capital Repayment at Term End: You must repay the entire loan amount at the end of the term, which requires a solid and well-managed plan.
Interest Accumulates: Over the life of the mortgage, you may end up paying more in interest compared to a repayment mortgage.
Property Price Risk: If your repayment strategy depends on selling the property, a decline in house prices could leave you short.
Investment Risk: Repayment strategies based on investments are subject to market fluctuations and may underperform.
Stricter Lending Criteria: These mortgages are more difficult to access, and not all lenders offer them for residential borrowers.

Interest Only vs Repayment Mortgages

Understanding the key differences between interest only and repayment mortgages is essential before making a decision.

Feature	Interest Only	Repayment
Monthly Repayments	Lower (interest only)	Higher (capital and interest)
End of Term Balance	Full loan amount remains	Loan fully repaid
Risk	Higher (repayment depends on investment performance)	Lower (predictable repayment)
Investment Requirement	Yes	No
Availability	More limited	Widely available

How Lenders Assess Repayment Strategies

Mortgage providers are required by the Financial Conduct Authority (FCA) to ensure that borrowers have a credible plan in place to repay the loan. The strategy must be realistic and verifiable. Lenders may ask for:

Evidence of investment performance
Confirmation of values from investment providers or financial institutions
Details of how your plan aligns with the mortgage term

It’s important to note that relying on future inheritance is generally not an acceptable form of repayment vehicle, as it’s uncertain and not under your control.

What Happens at the End of the Term?

At the end of an interest only mortgage term, you will be expected to repay the full outstanding loan balance. Failing to do so could result in serious consequences, including the forced sale of your property. This is why it is vital to have a well-structured and regularly reviewed repayment strategy.

If you’re unable to repay the capital, options may include extending the mortgage term (subject to lending criteria and age), remortgaging to another product, or selling the property to cover the balance.

Interest Only Mortgages for Buy-to-Let

Interest only mortgages are particularly popular among buy-to-let investors. Since the property is let out to tenants, landlords often prefer to keep monthly outgoings low to maximise income. The hope is that, over time, the property’s value will increase, allowing the capital to be repaid through profit from the eventual sale.

However, this strategy carries risks, such as property market downturns, changes in rental income, and evolving tax regulations that affect landlords’ profitability.

Who Offers Interest Only Mortgages?

Not all lenders offer interest only mortgages, and those that do typically have more stringent requirements. Many high street banks, specialist mortgage lenders, and intermediary-only lenders may offer this product, particularly for higher loan amounts or buy-to-let purposes. Approval is always subject to lending criteria and underwriting assessments.

Regulatory Environment and Consumer Protection

The FCA has introduced various measures to ensure borrowers are fully informed about the risks of interest only mortgages. Lenders must conduct affordability checks and assess repayment strategies to reduce the possibility of borrowers entering into unmanageable borrowing arrangements.

You are encouraged to regularly review your repayment plan to ensure it remains sufficient to clear the debt by the end of the term.

Alternatives to Interest Only Mortgages

If you are unsure whether an interest only mortgage is suitable, there are alternative options that might better match your financial circumstances, such as:

Repayment Mortgages: These allow you to repay both interest and capital and are typically considered lower risk.
Part and Part Mortgages: A hybrid model where you repay part of the loan on an interest only basis and part on a repayment basis.
Offset Mortgages: Link your mortgage to savings to reduce how much interest you pay.

Each option has its own benefits and considerations depending on your long-term goals, income, and financial position.

Final Thoughts

Interest only mortgages can be a useful financial solution in specific circumstances, offering lower monthly payments and potential investment opportunities. However, they require a sound and credible repayment strategy and are generally better suited to borrowers with the ability and discipline to manage their finances proactively.

Before entering into any mortgage agreement, it is important to carefully review all implications, risks, and responsibilities associated with your chosen mortgage type. As mortgage professionals, we can help you explore whether this type of product aligns with your goals and support you in identifying suitable solutions as possible based on your unique situation.