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Repayment and interest-only mortgages explained

Repayment and interest-only mortgages explained

Category: Mortgages

Updated: 05/06/2017
First Published: 15/08/2013

What is a repayment mortgage?

With a repayment mortgage, you pay back a small part of the loan and the interest at the same time and are guaranteed to pay off the whole loan at the end of the term – assuming you meet all the repayments, of course.

What is an interest-only mortgage?

With an interest-only mortgage, you never repay the actual loan and need a separate arrangement for this, such as an investment of some sort.

However, you might have a different plan...

You might be intending to sell your home at the end of the mortgage term and get a smaller house, banking on property prices to have risen enough for you to do this mortgage-free. In this scenario, you just want to pay the interest on your mortgage, as you intend to repay the loan when you sell your home.

This is often the route chosen by buy-to-let investors, as it is the cheapest kind of mortgage (as you're not paying back what you borrowed, or paying into an investment alongside your mortgage), but it's also the most risky, as you're relying on property prices which can go down as well as up.

Full repayment mortgages

This is the only sure method of repaying your mortgage within a set term.

Every month you pay back some of what you borrowed as well as interest. By the time the mortgage term finishes, you've repaid your loan in full.

Early on in a long mortgage (say, over 25 or 30 years) you might feel a bit disheartened at how slow your mortgage is shrinking because the amount of the original loan you repay is a small part of each repayment. But, as things progress, you repay more and more of what you borrowed and less and less interest, eventually bringing down the balance.

Most mortgages taken out are on a repayment basis. The monthly repayments are higher with a repayment loan, but that's because you are paying the loan off each month. It has the advantage of certainly paying off the loan at the end, which an interest-only loan doesn't give you.

Interest-only mortgages

This method does not guarantee you pay off your mortgage loan and works like this.

Let's say you borrow £150,000 on an interest-only basis, over 25 years, at an interest rate of 4%.

Your monthly mortgage payments only cover the interest of your mortgage (in this instance they would be £150,000 x 4% = £6,000. £6,000/12 = £500 per month).

Because you only ever pay the interest on what you borrowed, and never actually pay any of the loan back, you'll continue to owe £150,000 throughout the mortgage term.

At the end of the term you have to repay the mortgage, be it through using an investment, by selling your home, or by remortgaging.

An interest-only mortgage has a much cheaper monthly payment when compared to a full repayment mortgage, but this can be deceptive, as you're not paying back anything you borrow. You will usually need to be paying into some sort of investment each month to eventually repay the loan, and you will need to factor these payments into your budget.

So even though a full repayment mortgage can feel like a hard swim against the current, you are, at least, still moving; with an interest-only mortgage you're only ever treading water.

Repaying an interest-only mortgage using a "repayment vehicle"

A repayment vehicle means an investment you have running alongside your mortgage to repay it.

The investment you use to repay your mortgage could be an endowment policy, an ISA, your pension, stocks and shares, investment bonds, investment funds or a buy-to-let property, to name but a few.

People use investments to repay their mortgages in the hope they may be able to pay it off quicker than if they had a full repayment loan. However, this potential reward doesn't come without risks, namely:

  • Your investment may not perform well enough to repay your mortgage in full. A lot of people who bought endowment policies in the 1980s experienced dramatic shortfalls when they came to repay their mortgages. These people had to put a portion, or even their entire mortgage, onto repayment. Some have even paid more for their mortgage than borrowers who took out a mortgage on a full repayment basis.
  • You could end up paying more than you would have done on a full repayment mortgage. It can sometimes work out to be a false economy repaying your mortgage using an investment. If the investment takes longer to reach the amount needed to repay your mortgage, you'll be paying more interest and investing longer than you intended. You should make sure you compare an interest-only mortgage with a full repayment mortgage by adding your interest payment to any monthly amount you invest. However, this does not guarantee that repaying your mortgage this way will be cheaper.

Repaying your interest-only mortgage by selling your property

Something a lot of people do, particularly buy-to-let investors, is aim to repay their mortgage by selling the house or flat that is mortgaged. If you live in this property, you're probably hoping that any equity (the percentage of the property you own, e.g. if you have a £150,000 mortgage on a £300,000 property, your equity is 50%, or £150,000) is big enough to buy a smaller place.

The main risk with this option is that you may not have enough equity to buy somewhere else when the mortgage finishes. This is particularly the case with lower valued property, as you'll only own a portion of your home.

As there is a big unknown with this, which is whether house prices will perform as you expect, many mortgage lenders do not allow interest-only loans on this basis.

A part repayment/part interest-only mortgage

You may not be able to afford a mortgage on full repayment, or you may have an under-performing investment, the shortfall on which you need to plug.

In this instance, you could have part of your mortgage on repayment and part of it interest-only, with the two halves operating in the same way as described above.

If you're looking at this option due to concerns about affording your mortgage, be sure to have a plan. If you can't afford your mortgage, maybe a less expensive property is an option? How will you eventually pay the entire mortgage off?

You need to be clear about these things before you take out your loan.

One final note – interest-only mortgages are less easy to come by than repayment ones, largely thanks to the difficulties they caused during the financial crisis. A large number of people were approaching the end of their mortgage term with no way to repay the loan, so residential mortgage providers are moving away from this style of lending to prevent the same issue occurring in the future. Repayment mortgages are now the main (and often only) way to secure a loan on your property, with the rules becoming stricter to place responsibility on the lender for ensuring you can afford to repay your mortgage in full.

What next?

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Disclaimer: This information is intended solely to provide guidance and is not financial advice. Moneyfacts will not be liable for any loss arising from your use or reliance on this information. If you are in any doubt, Moneyfacts recommends you obtain independent financial advice.

 
 

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