Mortgages  

What is an interest-only mortgage?

This article is part of
Guide to interest-only mortgages

What is an interest-only mortgage?

Interest-only mortgages are home loans on which borrowers pay only the interest due on their debt, rather than paying down the capital at the same time.

As a result, interest-only mortgages are – initially – cheaper to service than repayment mortgages, with lower monthly payments due until the end of the mortgage term.

How do they work?

While borrowers pay only the interest on their debt, rather than paying down the capital at the same time this means that when the mortgage term comes to an end, the whole initial loan has to be paid off.

Using an example from UK Finance, a borrower takes out a £100,000 loan over a 25-year term, with an interest rate of 3 per cent, fixed for life.

On an interest-only basis, the borrower pays £250 per month for 25 years - £75,000 in total - then owes the capital sum of £100,000 at the end of the 25-year term – which is a total of £175,000 paid back to the lender.

By comparison, on a capital and interest basis, the borrower pays £474 per month for 25 years - £142,000 in total - then owes nothing – meaning the total is £142,000 paid by the end of the mortgage term.

Borrowers who take out interest-only mortgages are expected to have put plans in place to enable them to repay the loan, for example, a savings plan or other investments.

How many people have interest-only mortgages?

According to figures from UK Finance, in 2012 there were some 3.2 million interest-only loans outstanding.

This included both interest-only and part-and-part mortgages, a combination of both interest-only and repayment, and was equivalent to a third of all homeowner mortgages.

Following work by the industry and lenders to help borrowers and reduce the size of the interest-only book, UK Finance has said there are now 1.7 million interest-only mortgages outstanding.

These include partial interest-only, which is down 46 per cent since 2012, when this data was first collected.

The total value of the interest-only mortgage book is now £250bn, down 37 per cent in the same period.

There were 1,293,000 pure interest-only homeowner mortgages outstanding at the end of 2017, a 14.9 per cent fall over the last year, while there were 429,000 partial interest-only homeowner mortgages outstanding at the end of 2017 - a 2.1 per cent increase over the last year.

The number of interest-only loans at greater than (more than 75 per cent) loan-to-values (LTV) fell by 13.9 per cent in 2017.

Loans at these higher LTVs now make up 13 per cent of the total, compared with 16 per cent in 2016 and 36 per cent in 2012.

The Financial Conduct Authority (FCA) has said interest-only mortgages were originally aimed at niche groups of consumers, such as high net worth consumers, and those wishing to take advantage of specific types of tax break, where the mortgage was usually linked to an investment policy assigned to the lender.

However, over time their availability widened considerably, despite accompanying repayment vehicles enjoying a less favourable tax treatment, with few questions being asked as to why an interest-only mortgage was required by the borrower, or how capital would be repaid at the end of the term.