Interest only mortgages

Top Tips

What You Need to Know

  1. An interest-only mortgage is a mortgage which requires you to pay the monthly interest charge on the principal amount you have borrowed, or is outstanding, and you do not pay off the actual debt itself.
  2. They can be a risky option as if the value of your house goes down, you could find yourself owing more than your house is worth.
  3. They usually require a high deposit and leave you paying more interest, as well as putting you at the mercy of interest-rate changes, which will determine how much you are repaying.
  4. They are popular with buy-to-let landlords as they can reclaim tax on the interest on a mortgage and they also help to maximise rental yields.
  5. Interest-only mortgages used to be popular with low-income families, but the risks associated with lending in such circumstances are considerable.
  6. Since the 2008 economic crisis, borrowers now have to have a credible plan for repaying the debt before they are allowed to take out an interest-only mortgage.

What is an Interest-Only Mortgage?

An interest-only mortgage is a mortgage which only requires you to repay the interest on the amount you have borrowed, not the actual debt itself. This of course means that you will still owe the lender the amount you originally borrowed, at the end of the mortgage period.

For example, if you borrow £150,000 for a period of 25 years, with an agreed interest rate of 5%, you will be making payments of £625 a month if you opt for an interest-only mortgage. But at the end of the 25 year period, you will still owe the lender the original £150,000 you borrowed.

They are in many ways a gamble, as if the value of the property goes down, the borrower can end up owing more than they have borrowed, but if it goes up, they will own an asset worth more than the debt on it.

In recent years property values in parts of the UK have also been climbing steadily, and if you were to buy a property using the interest-only £150,000 mortgage detailed above, and that trend were to continue, you might still owe the original £150,000 you borrowed, but the value of your house will be much higher. This is what borrowers, and lenders hope will happen. But there are no guarantees, which is why interest-only mortgages are considered to be a risky option.

They used to be very popular with low-income households, because the monthly repayment costs are so low meaning that they can afford a better property. However, the practice of routinely offering them to low-income households has now been curtailed following the recent economic crisis.

They are still a popular option with buy-to-let landlords, as they can claim the tax back against the interest on a mortgage, but not on any capital repayments they make. Lower monthly outgoings also increases the yield they will be receiving from the rent, which is the main source of profit for them.


What are the disadvantages?

There are a number of potential disadvantages to taking out an interest-only mortgage at the current time:

  • Negative Equity: Property prices do not always go up. Sometimes they will drop as well, and if that is the case a borrower can find themselves in a situation known as negative equity. That is when they owe an amount of money on a house, but the value of that house if lower than what they owe.

For example, if you buy a house worth £150,000 using the mortgage detailed above, but the value of that house were to drop to £125,000 by the end of the mortgage, you would still owe the £150,000 you originally borrowed.

This is not only a risk for borrowers, but for lenders as well, as when this happens, they very often don’t get all of their money back. For that reason, in recent years, lenders have been reluctant to offer interest-only mortgages, although a few have been appearing in the last 18 months or so.

  • High Deposits: An interest-only mortgage is considered by the lender to be a higher risk than a regular mortgage, and this means that the costs associated with obtaining one are higher. Any fees required upfront are likely to be steep, but also the deposit you have to be able to put down is also more.

Whereas it is relatively simple to get a regular mortgage with a deposit of just 10% or even 5%, you are likely to need to be able to find 20% or even 25% as a minimum deposit for an interest-only mortgage.

  • Interest Rate Rises: Another inherent risk with an interest-only mortgage, is that interest rates can change, and this means that the amount you have to pay back can change as well.

If you are on a fixed term agreement, you can be sure of what you will be paying for the duration of that agreement, but most agreements of this nature last no more than 2, 3, or perhaps 5 years. After this period, you could be forced to agree to a much more expensive agreement if interest rates are higher.

If you are on a variable rate mortgage, this means that if interest rates go up, your repayments can as well, with little or no warning. This can be problematic if money is tight.

It is therefore advisable to build up a separate fund to allow you to be able to make payments should your monthly costs go up. Failure to make repayments will lead to further financial charges, and could potentially see the house repossessed.

  • More interest: Interest-only mortgages mean that you will end up paying more interest in total than a regular mortgage. This is because the interest you pay is charged on the amount of money you owe the lender.

With a regular mortgage, you are paying down your debt, and as it decreases, so the amount of interest you have to pay does as well. With an interest-only mortgage you are not paying down the debt, so the interest is always calculated on the full amount and is therefore more.


Bad Press

Interest-only Mortgages have received a lot of bad press since the economic crisis of 2008, which they were one of the main contributory factors in.

In the US, it was common practice to offer an interest-only mortgage, alongside an endowment policy (which is a life insurance contract intended to pay a lump sum after a specific length of time – i.e. when it matures - or on death).

These products performed very badly, and house prices in the US declined making the debt held by many financial institutions worthless and beginning the panic which led to the worldwide economic crash.

As a result of this, new regulations were introduced in many countries to control the issuing of such risky mortgages to people who were at a high risk of defaulting on their payments.

The UK was no exception and the market for issuing interest-only mortgages is now much smaller than it once was.

New UK Regulations

The period between 2000 and 2007 was seen as boom years for UK property with prices rising significantly and the appetite for interest-only mortgages going up with them. BY 2007 around a third of all mortgages taken in the UK were interest-only mortgages.

After the economic crisis hit, the Financial Conduct Authority (now the Financial Services Authority) conducted a review into the mortgage market and this led to strict new regulations on the issuing of interest-only mortgages.

With Endowment Policies now in sharp decline, it is no longer acceptable to rely on a predicted increase in house prices to cover the cost of your existing debt. Rather, if you want to take out an interest-only mortgage, you have to be able to provide a credible means of paying back the whole debt you are taking on.

Different lenders will require different details, so it is worth speaking to them directly about this, or to an independent mortgage broker, before proceeding with any applications.

Is Interest-Only ever a good idea?

In some circumstances, an interest-only policy can work.

If you live in London or the south-east of England, or in certain other areas, an interest-only mortgage can be a cheaper option than renting, with the added bonus that you are on the property ladder and own your own home as well.

Nowadays, if you do decide to go down this route, it is advisable to look to switch to a repayment mortgage as soon as possible. You should also be looking to save money alongside your mortgage to cover yourself should interest rates change.

If house prices continue to go up, which seems likely, it should work out for you, but if they drop, which is always possible, you could be at risk of losing your home.

It is also vital if you do go down this route to stick to your plan for repaying the total debt. If you don’t manage to repay the debt, then all you are doing is effectively renting from the bank, with the added costs and problems of maintaining the home that a landlord would usually sort out for you.

Further Reading



Leave a Comment on this Article
leave comment >
How we use cookies


We Guide, You Decide