Interest only mortgages: a beginner's guide

Curious about interest only mortgages? We explain what they are, who they are for, and how to get one

Interest only mortgages
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Interest only mortgages used be a fairly common financial product up until the financial crisis of 2008, when it transpired that many people who had borrowed on an interest-only basis were not going to be in any position to repay the loan following the financial crash that affected their savings and investments. Having said that, interest only mortgages are still available; in fact, they are showing an upward trend, which means more such mortgages are becoming available. 

If your quest for finding the best mortgage deal has not yielded the results you had hoped for, that is the monthly repayments on the property you really want would be clashing with other long-term financial goals you have, you could well consider taking out an interest only mortgage. Below, we explain everything you need to know about this type of mortgage and whether it's a good idea for you. If you're ready to play around with numbers, jump straight down to Habito's free mortgage comparison tool at the bottom of the page.

What is an interest only mortgage?

An interest only mortgage simply is a mortgage plan where you repay only the interest amount each month for the duration of the mortgage term. At the end of the mortgage term agreed with the lender, the whole of the original loan amount becomes repayable, minus the interest. So, basically, if you borrowed £200,000, you still owe the £200,000 at the end, but not the interest the lender would've charged you on the loan. 

This article covers residential interest only mortgages; for buy-to-let mortgages, which typically are interest only, see our buy to let mortgage guide. Need more general advice on the different mortgage types out there? Read our guide to mortgages for first time buyers.  

Can you still get an interest only mortgage?

Contrary to popular belief, you still can get interest only mortgages: they haven't been banned and are offered by quite a few lenders. What is true is that the lending criteria are now much, much stricter than they used to be, so not everyone will be able to get one.

Why would you get an interest only mortgage?

An interest only mortgage can work very well for some people: namely, for those with very clear, long-term financial plans that involve inheritance (whether in the form of funds or property), ISAs or investment plans, or a combination of all of those. Think of the interest only mortgage as a good option if you would categorise yourself as 'cash poor, asset rich', or 'will be richer in the future'. Repaying only the interest on your mortgage could free up substantial sums every month that could go towards savings and/or your living expenses. 

Interest only mortgages should not be thought of as 'I'll think about it it later' mortgages, and, in any case, lenders no longer allow this kind of borrowing. Anyone applying for an interest only mortgage will need to demonstrate a concrete repayment plan to the lender, of which more below.

There also is a subset product in this category called the retirement interest only mortgage, which is a fairly recent invention to help older people who would otherwise struggle to qualify for a mortgage. It can be a good option for reitred people who don't need to worry about passing on the property as inheritance to children or other family members. 

Repayment plans: what you need to know

If you apply for an interest only mortgage, you will need something called a repayment plan or repayment strategy. Different lenders will have different preferences for what they will accept as a reliable plan, while some will want even more reassurance with a combination of different strategies. Think of it almost as a business plan you'll need to pitch to a lender. Any of the following could be accepted by a lender as legitimate repayment plans:

  • Property you will gain possession of following the passing of a relative that will be sold; this repayment is also used for retirement interest-only mortgages;
  • Future inheritance;
  • Your intent to sell the property upon the completion of the mortgage term, sometimes referred to as downsizing; note that most lenders will not accept this option unless you own at least £200,000 of the equity at the end of the mortgage term;
  • Financial surplus from ISAs, an investment portfolio, or stocks and shares. Note that lenders understand the nature of investment very well, and will need you to demonstrate that your investment strategy is sound and will yield the expected profits. If you're investing into something very high risk, expect to be turned down by the lender;
  • A pension cash-in: you can use 25 per cent of your pension pot tax-free in order to pay off the loan; note that if you cash in the rest, it will be taxed as income. Using the 25 per cent lump sum can be an option in conjunction with other repayment strategies;
  • The future sale of valuables you own/are due to inherit: if you're among the lucky few to own an expensive painting/cultural artefact/piece of jewellery, these could be used to repay the loan. 

How much can I borrow on an interest only mortgage?

Expect to be able to borrow no more than 75 per cent of the property's value. There are very few lenders who will accept anything less than a 25 per cent deposit, and most will prefer a 50 per cent deposit.

Do also note that most lenders will want to see that large deposit combined with at least £50,000 in annual income (£75,000 for a couple). This can be income from being self employed.

How long are interest only mortgage terms?

The terms will vary, but most will be a standard 25-year term.

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

That depends on whether you had planned on selling or keeping the property, and what repayment plan is in place to help you repay the loan. You will need to think about this carefully before taking on an interest only mortgage. Are you sure you'll be prepared to move out after living in your home for so may years? 

Is an interest only mortgage a good idea?

Which brings us neatly to the more general question of, 'are interest only mortgages a good idea'? Given the very tight eligibility criteria, they won't be for many, as not many people will want the hassle of the application process and the high chance of being turned down. Having said that, there is a signficant minority that could benefit from an interest only mortgage. They are:

  • People nearing retirement who would struggle to make large mortgage repayments and who are prepared for their home to be sold when they go into a home/die;
  • People with significant funds tied up in family owned property, trust funds/inheritance who would like to own their own home before coming into that money;
  • People who are very serious about investment: if you have a very good financial advisor/understand investment and how to diversify your income from it, and would like your money to work harder over the years, this could be for you. This is likely to only work if you invest/save at least the amount you would have spent on mortgage repayments. 

When is an interest only mortgage a bad idea, even if you qualify? By far the biggest potential pitfall is ending up in negative equity and not being able to repay the loan, if you were hoping to cover it with the sale of the house. For that reason, it's not recommended to use this mortgage if purchasing a new build home. Not being to repay the loan for other reasons should not be a concern, as the lender simply wouldn't approve your application in the first place.

Comparing mortgages

Feeling confident that an interest only mortgage would work for you? Then it's time to confront the numbers, using the online mortgage expert Habito's online comparison tool below.