Interest only mortgages explained
Warning: THE MORTGAGED PROPERTY (WHICH MAY BE YOUR HOME) MAY BE REPOSSESSED IF YOU DO NOT KEEP UP REPAYMENTS ON YOUR MORTGAGE
What is an interest only mortgage?
If you have an interest only mortgage, your monthly payments only cover the interest on the money you borrowed, rather than paying back the loan itself. At the end of the mortgage, you must have a repayment strategy to pay back the money you borrowed.
There are a lot of myths and misconceptions surrounding interest only mortgages – that’s why we’ve put together this guide. It answers the big interest only questions: what it is, how it works, and how much you’ll actually end up paying.
1. Interest only vs. repayment: how mortgage repayments work
The two most common ways of paying back a mortgage are called interest only and repayment. To understand the difference, we need to know how mortgage repayments work.
When you have a mortgage, you pay back some money every month to your lender. If you have a repayment mortgage, your monthly payments are made up of two parts: the capital, which is the money you borrowed, and the interest, which is extra money you have to pay back to your lender (think of it as the cost of borrowing money). By the time the mortgage term ends, everything will usually be paid off, as long as you don’t fall behind on your monthly payments. There may be extra fees to pay off at the end of the mortgage term - this is known as a redemption fee. Your lender should let you know if you need to pay any redemption fees.
If you have an interest only mortgage, your monthly repayments will be made up of only the interest, not the capital. This means that you will pay the interest on your mortgage throughout the mortgage term - and then, when you get to the end of your mortgage, you have to pay back all the money you borrowed in one go.
To do this, you need to have a plan in place to pay back the money. This is known as a “repayment vehicle”, or "repayment strategy". There are a number of different repayment strategies. You will need to prove to your lender that your repayment strategy will leave you with enough money at the end of your mortgage to pay everything back.
This is key. There’s a lot of pressure on lenders to make sure you can pay back the capital at the end of the mortgage, so expect to be asked a lot of questions about your finances and repayment plan if you apply. Your lender will also usually check throughout the mortgage term that your repayment plan is still in place.
2. Interest only mortgages can offer lower monthly repayments
If you have an interest only mortgage, your monthly payments will be lower than if you had a repayment mortgage, because you aren’t paying back the capital.
That's the chief benefit of an interest only mortgage: you don’t have to pay back as much money every month, which may leave you with more in your pocket than if you had a repayment mortgage. But interest only mortgages usually end up costing more overall, because of the way interest rates are calculated. (You may also have to budget for the cost of your repayment strategy.)
3. Interest only mortgages tend to be more expensive overall
Let’s say you take out a £200,000 mortgage at a 5% interest rate. You have a £20,000 deposit, so you owe your lender £180,000. To keep things simple, we’ll assume that interest rates stay at 5% for the entire mortgage, and we’ll also assume that interest is calculated once every year.
When interest is calculated, it is based on the amount of capital you have left to repay, not the original amount you borrowed. So, if you have a repayment mortgage, the overall interest you have to pay will be lower, because you’re always paying off small amounts of the capital.
For example: by the end of your first year, you will have paid off a small chunk of your mortgage, so you have £176,291 left to pay. When your lender next calculates interest on your mortgage, they’re not calculating 5% of £180,000 (the money you originally borrowed), they’re calculating 5% of £176,291.
Every year, you will pay off more of your loan, so less and less interest will be added every time it’s calculated.
But if you have an interest only mortgage, you’re not paying off the capital, so the amount of interest added every year isn’t going down.
Although the interest payments on a repayment mortgage go down over time, the overall monthly payments don’t. Instead, less money goes on paying off the interest, and more money goes on paying off the capital.
4. You can switch to a repayment mortgage later
If you take out an interest only mortgage, you can usually switch to a repayment mortgage later. For example, if you take out a 25-year mortgage, you could go interest only for the first five years, and then switch.
But, if you do choose to switch, your monthly repayments will increase quite a lot. In most cases, they will be even higher than if you had a repayment mortgage from the start. This is because you normally have to pay off the whole mortgage over a shorter period of time (in this example, 20 years rather than 25 years).
Once you’ve switched to a repayment mortgage, you don’t need to worry about finding a way to pay back the loan and the end of the mortgage term. As long as you keep up your mortgage payments, all of your debt, including interest, will usually be cleared at the end. But you should check with your lender that there won't be any fees to pay at the end of the mortgage term.
If you do switch from an interest only mortgage to a repayment mortgage, you normally can’t switch back to interest only again in the future.
5. Part-and-part mortgages are a third option
Many lenders offer a third repayment option: part-and-part mortgages. If you have a part-and-part mortgage, you pay back some capital and some interest every month, but at the end of your mortgage there will still be capital left to pay. Part-and-part mortgages are the least common of the three types.
Part-and-part mortgages are often used by people who already have a repayment strategy in place to pay off a good chunk of their mortgage capital - but not all of it. By paying part of their mortgage on an interest only basis, they can have lower monthly repayments. Then, when the mortgage comes to an end, they use the repayment strategy to pay off the leftover capital.
Interested in interest only?
This guide is intended as a summary only and does not constitute financial or legal advice given by Leeds Building Society. No reliance should be placed on this guide. We recommend that you seek independent financial/legal advice if you have any questions or queries.
The figures used in this guide are only meant as a general indication as to how interest only mortgages work. Speak to a mortgage adviser for more specific figures.