When you take out a mortgage you must choose how you are going to repay it. You can either go for an interest-only or a repayment mortgage. Read our guide so you can make an informed decision about how to pay back your mortgage.
Interest-only and repayment aren't different types of mortgages, they are different ways of repaying. No matter which you choose you will still also have to decide whether to go for a fixed, discount or tracker interest rate on your mortgage. You can find out more about the different interest rates on offer with our Introduction to Mortgages. But, in this guide we're dealing only with how you repay your mortgage. So, what does interest-only and repayment mean?
With a repayment mortgage, every month you pay back both the interest on your mortgage AND some of the loan itself. By the end of the mortgage term, usually 25 years, you have paid off the entire debt.
With an interest-only mortgage, you only pay back the interest on your loan. This means your monthly payments are much lower, but you will still need to pay off the loan at the end of the mortgage term.
Interest-Only
Lower monthly payments - As you are only paying back the interest on your loan your monthly payments will be far lower than with a repayment mortgage. For example, a £150,000 25-year mortgage with a 3.5% rate, would cost £751 a month on a repayment basis, but just £438 with an interest-only mortgage. You can calculate the difference to your repayments with this calculator.
Control over your investments - You can decide how you save to repay the capital of your mortgage. You could put the money you save each month into home improvements as well as putting a little each month into a savings plan.
Chance to profit - If the investment vehicle you choose to use to save up the money to repay your capital performs well you may end up with a lump sum after you have paid off your mortgage.
More expensive - With a repayment mortgage every year the amount of interest you owe decreases as it is being paid on a smaller and smaller loan, but with an interest-only mortgage the capital owed isn't shrinking so you continue to pay interest on the full amount. So over 25 years on a £150,000 mortgage at a rate of 4.5% a repayment mortgage holder would pay £100,125 in interest, but an interest-only mortgage holder would pay £168,750.
One day you will have to pay - At the end of your mortgage you will still owe the lender the initial amount you borrowed. So, while you are enjoying smaller monthly repayments you need to have a plan in place for how you will pay back the capital, otherwise you may lose your home.
Capital Repayment
Cheaper - You will pay less interest overall with a repayment mortgage and, as the years go on, you'll have access to better interest rates. This is because you will constantly be building up equity in your home as you pay off the capital borrowed, so when you remortgage you'll qualify for better interest rates.
Peace of mind - As long as you keep up repayments, you are guaranteed to own your home at the end of your mortgage term.
Simple - No need to worry about how your investments are performing.
Higher repayments - Because you are paying off the capital of your loan as well as the interest you will pay back more each month.
Most borrowers should avoid interest-only mortgages unless you are confident that you have savings that can pay off the capital. Most banks will now insist on seeing evidence of this so-called ‘investment vehicle’ before handing out an interest-only mortgage. Banks will not allow you to rely on house price growth, or even the promise of an inheritance, as a means of repaying the loan. However, if you are a buy-to-let investor interest-only may be the way to go. Most buy-to-let mortgages are repaid on an interest-only basis. This is because it is assumed the property will be sold to repay the mortgage (although this relies on house prices being resilient so the property is worth the same or more than was paid for it). Also, with buy-to-let investments mortgage interest can be offset against rental income for tax purposes, so it makes sense to continue to pay the full amount of interest on the debt in order to be able to maximise the amount of tax you can offset.