When it comes to choosing a mortgage, there are two main options: interest only and repayment. Each has its own advantages and disadvantages, and it’s important to understand the differences before making a decision. This guide will help you weigh the pros and cons of each type of mortgage and make an informed choice.
What is an interest-only mortgage?
An interest-only mortgage is a type of mortgage where you only pay the interest on the loan each month, rather than paying off any of the principal. This means that your monthly payments will be lower than with a repayment mortgage, but you will still owe the full amount of the loan at the end of the term.
Interest-only mortgages are often used by investors or those who expect to have a large lump sum of money at the end of the term to pay off the loan. There are several types of interest-only mortgages available for buying a property in the UK, below are some of the most common ones:
1. Standard interest-only mortgage
With this type of mortgage, you only pay the interest on the amount you borrow each month. The capital amount borrowed remains the same throughout the term of the mortgage. This type of mortgage is suitable for people who have a repayment vehicle in place, such as an endowment policy or ISA, that will pay off the capital at the end of the mortgage term.
2. Buy-to-let interest-only mortgage
A buy-to-let interest-only mortgage is specifically designed for people who want to buy a property to rent out. With this type of mortgage, you only pay the interest on the amount borrowed each month. The loan is usually secured against the rental income from the property, rather than the borrower’s income.
Another important aspect to consider with a buy-to-let mortgage is that you will be considered a landlord and therefore, you will be required to submit a tax return for rental income.
3. Lifetime interest-only mortgage
A lifetime interest-only mortgage is designed for older borrowers who want to release equity from their property without having to make any repayments. With this type of mortgage, the interest is added to the loan each month, and the loan is repaid when the property is sold, or the borrower passes away.
It’s important to note that interest-only mortgages require a separate repayment vehicle to pay off the loan at the end of the term, and borrowers should have a robust plan in place to avoid potential financial difficulties in the future.
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What is a repayment mortgage?
A repayment mortgage is a type of mortgage where you pay both the interest on the loan and a portion of the principal each month. This means that your monthly payments will be higher than with an interest-only mortgage, but you will be paying off the loan over time and will eventually own your home outright.
Repayment mortgages are often used by those who want to own their home and have a stable, predictable monthly payment. Here are some common types of repayment mortgages:
1. Fixed-rate mortgages
With a fixed-rate mortgage, the interest rate is fixed for a specified period, typically 2, 3, or 5 years. During this time, your monthly payments remain the same, regardless of any changes in the Bank of England base rate.
2. Tracker mortgages
A tracker mortgage has an interest rate that tracks the Bank of England base rate, meaning that your monthly payments can go up or down depending on changes in the base rate.
3. Discounted mortgages
With a discounted mortgage, the interest rate is set at a discount to the lender’s standard variable rate for a specified period. During this time, your monthly payments are lower than they would be on the standard variable rate.
4. Offset mortgages
An offset mortgage links your mortgage to your savings account. The amount you have in savings is offset against the amount you owe on your mortgage, meaning that you pay interest on a lower amount. This can help you to pay off your mortgage faster.
5. Flexible mortgages
A flexible mortgage allows you to overpay, underpay, or take payment holidays, depending on your financial situation. This can be a useful option if you want to pay off your mortgage faster or have an irregular income.
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Pros and cons of interest-only mortgages
Interest-only mortgages can be attractive to those who want lower monthly payments in the short term. However, they come with some risks. With an interest-only mortgage, you are only paying the interest on the loan each month, so the principal amount remains the same.
This means that you will need to have a plan in place to pay off the principal at the end of the mortgage term. Additionally, interest-only mortgages often have higher interest rates than repayment mortgages, which can result in higher overall costs over the life of the loan.
Benefits of interest-only Mortgage
- Lower monthly payments
One of the main benefits of an interest-only mortgage is that the monthly payments are lower than those on a repayment mortgage, as you are only paying the interest on the loan.
- Greater affordability
Because the monthly payments are lower, you may be able to afford a larger mortgage, which could allow you to buy a more expensive property or to keep your monthly payments within a budget.
- More flexibility
Interest-only mortgages offer more flexibility than repayment mortgages, as you have the option to make lump sum payments to reduce the amount of the loan or to switch to a repayment mortgage at any time.
- Potential for investment returns
With an interest-only mortgage, you have the opportunity to invest the money you would have paid towards the capital repayment of the loan, which could potentially earn a higher return than the interest rate on the mortgage.
- Tax benefits
If you are a higher-rate taxpayer, you may be able to claim tax relief on the interest payments of an interest-only mortgage, which could make it a more attractive option for you.
Disadvantages of an Interest-Only Morgtage
- Higher risk of negative equity
With an interest-only mortgage, you only pay off the interest on the loan, which means you don’t reduce the amount of the loan itself. This increases the risk of negative equity, which can occur when the value of your property falls below the amount you owe on the mortgage.
- Higher overall interest payments
Because you are not paying off any of the loan itself, the total amount of interest you pay over the term of the mortgage will be higher than with a repayment mortgage.
- Limited availability
Interest-only mortgages are not as widely available as they used to be and may be more difficult to find, particularly for first-time buyers.
- Endowment mortgage risk
In the past, many interest-only mortgages were taken out with an endowment policy, which was intended to repay the loan at the end of the term. However, there have been cases where the endowment policy has not generated enough funds to pay off the loan, leaving the borrower with a shortfall.
Pros and cons of repayment mortgages
Repayment mortgages are a more traditional option where you pay both the interest and the principal amount each month. This means that you are gradually paying off the loan over time, and at the end of the mortgage term, you will have fully paid off the loan (assuming all payments have been made in full).
Benefits of Repayment Mortgage
- Pay off the loan
With a repayment mortgage, you gradually pay off the loan over the term of the mortgage, so you will own your property outright at the end of the term, assuming all payments have been made in full.
- Certainty of payments
With a fixed-rate mortgage, your monthly payments remain the same for the fixed-rate period, giving you certainty and making it easier to budget.
- Lower overall interest payments
Because you are paying off the loan, rather than just the interest, over the term of the mortgage, you will pay less interest overall compared to an interest-only mortgage.
- Equity in your property
As you pay off the loan, you will build up equity in your property. This can be used to finance future purchases, such as buying a bigger property or taking out a loan against equity.
- Lower risk
With a repayment mortgage, there is less risk of falling into negative equity, which can occur with interest-only mortgages, where the value of the property falls below the amount owed on the mortgage.
- Better mortgage rates
Lenders often offer better interest rates for repayment mortgages compared to interest-only mortgages, as they view them as less risky.
Disadvantages of a Repayment Mortgage
- Higher initial monthly payments
Monthly payments on a repayment mortgage are typically higher than those on an interest-only mortgage, especially during the early years of the mortgage.
- Limited affordability
Because monthly payments are higher, you may not be able to afford as large a mortgage as you would with an interest-only mortgage, which could limit your purchasing power.
- Higher overall cost
While you pay less interest overall with a repayment mortgage, the higher monthly payments mean that the total cost of the mortgage is likely to be higher than with an interest-only mortgage.
- Less flexibility
With a repayment mortgage, you are committed to paying off the loan over the term of the mortgage, which can limit your flexibility to make other financial decisions, such as investing in other assets.
Part and part mortgage: The Middleground
A part and part mortgage is a combination of an interest-only mortgage and a repayment mortgage. With this type of mortgage, you pay interest on a portion of the loan and make capital repayments on the rest. This can be a good option for those who want to pay off part of their mortgage while also having lower monthly payments.
How to decide which type of mortgage is right for you
When deciding between an interest-only mortgage and a repayment mortgage, it’s important to consider your financial situation and goals. If you are looking for lower monthly payments and have a plan in place to pay off the principal at the end of the term, an interest-only mortgage may be a good option.
However, if you want the security of knowing that you will fully own your home at the end of the term and can afford higher monthly payments, a repayment mortgage may be the better choice.
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