How do interest-only mortgages work?

If you’ve ever wondered what an interest-only mortgage is, or are considering choosing one, read on to find out how it works.

Jim Kersey Published on 21 September 2018. Last updated on 20 January 2021.
How do interest-only mortgages work?

An interest-only mortgage is one of the many types of mortgage options available today. While this is not as popular as it was before the 2008 financial crisis that left banks stricter about their lending options, there are still some lenders out there who are willing to offer interest only-mortgages, though they can be trickier to obtain.

Interest-only mortgages are considered higher risk than other types, so as with any financial decision, they’re not to be rushed into. Your future finances will no doubt thank you for taking some time in advance to understand exactly how interest-only mortgages work.

Mortgage basics

Before we can look at how interest-only mortgages work, here’s a quick refresher on the basic function of a mortgage. Essentially, these loans allow you to buy property that you wouldn’t otherwise have the money for up front.

By securing loans from lenders, you can purchase a property, with an arrangement to repay the outstanding sum over a period of time. And of course, this will come with an added interest rate and various other fees, from which banks and building societies make their money.

So when you take out a repayment mortgage, you will eventually pay back the whole amount over a set period of time – either entirely through monthly payments or when you come to sell the property.

So what is an interest-only mortgage?

A large motivation for getting a mortgage in the first place is the ability to buy a house that you don't have the capital to buy outright.

The difference with an interest-only mortgage is that you are not paying back any of the capital borrowed.

With any type of mortgage, you will pay for this ‘privilege’. Banks charge interest on your mortgage loan as well as fees that you pay back usually in monthly instalments.

Your monthly repayments on a standard mortgage will consist of varying percentages of:

  • The capital borrowed
  • The interest accrued
  • Any fees incurred

The difference with an interest-only mortgage is that you are not paying back any of the capital borrowed. If you borrow £100,000, you will still owe £100,000 at the end of your mortgage term having only made repayments on to clear the interest on the loan, at the rate set by the bank on the loan.

This means you will make lower monthly mortgage repayments than if you were to take out a standard repayment loan.

Interest only loans can be taken out on both variable or fixed interest rate.

Once the term is over however, and you have paid the interest on the loan, you will then have to – one way or another – pay back the full sum borrowed.

Who can benefit from an interest-only mortgage?

Interest-only mortgages can be a good option in the right circumstances.

The attraction of an interest-only mortgage is all about the lower monthly-repayments.

If you know you have a time frame in mind to sell the property you could keep your monthly payments low and use the sale to pay back the capital sum borrowed.

Alternatively, perhaps you’re due a windfall from another investment or the sales of certain assets, an inheritance or a major increase in income, that you are confident will enable you to make the full repayment when it becomes due.

The attraction of an interest-only mortgage is all about the lower monthly-repayments.

However, it’s worth remembering, the interest on the mortgages is charged on the full outstanding debt – which on interest only mortgages, never decreases.

The risk factor

Clearly there is a risk factor involved here. If you can’t afford to pay off the loan you will be at risk of your home being repossessed.

Due to the innate risk involved in this method, lenders can demand evidence from you for how you are going to eventually pay off the loan.

Investments and property values cannot be guaranteed. Both can go up and down in value and the property market will not always enable you to make a quick or easy sale.

All these risks need to be thought through before committing to the loan.

Other mortgage types:
  • Cashback mortgages
  • Offset mortgages
  • Flexible mortgages
  • First time buyer mortgages
  • Buy to let mortgages
  • Repayment mortgages
  • Fixed rate mortgages
  • Variable rate mortgages
  • Tracker mortgages
  • Discounted rate mortgages

Is an interest-only mortgage the best choice for you?

Interest-only mortgages are a potentially risky option, unless you’re certain about where the eventual funds for the loan will come from. But they also bring with them a solution for certain circumstances.

Like all mortgage types, the suitability of a particular arrangement will depend on your current and future circumstances. With a long term strategy in mind, try to imagine what will save you the most money in the future and whether you may encounter any pitfalls or obstacles along the way and always seek professional advice if you feel you need help in understanding your options.

About the author:

Jim brings together unique data insights, contextual knowledge and thought provoking themes, to shed new light on important issues affecting both UK businesses and individuals. Read more

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