When applying for a mortgage, you need to decide how you want to repay it — as an interest-only or repayment mortgage. The two types have key differences between them and we’ll explain what those are to help you make a decision.
What is a repayment mortgage?
With a repayment mortgage, the monthly amount you pay is comprised of two parts. One part goes towards repaying the loan amount you borrowed, which is the capital. The other part pays the interest due on the loan.
The monthly repayment amount is calculated so that your entire loan is repaid by the time your term, such as 25 years, comes to an end. Once the loan has been cleared, you’ll own your property outright. During the initial years of your term, the interest aspect of your monthly payments will be higher than the repayment aspect. As the loan amount decreases, however, so too will the amount of interest that becomes payable.
What is an interest-only mortgage?
With an interest-only mortgage, you only pay the interest that’s charged on the loan each month. This makes it a much cheaper option than a repayment mortgage. However, you need to bear in mind that none of the capital is repaid during your mortgage term. This means that the entire loan has to be repaid at the end of the term. For example, if you take out an interest-only mortgage of £300,000 over a 25-year term for your new home in Bexleyheath, you’ll still have an outstanding debt of £300,000 to repay in 25 years’ time.
You’ll need to provide the lender with a repayment plan for the capital. This could be selling the property at the end of the term, for example. Or using a lump sum from your pension or savings from an investment portfolio.
The overall amount you pay over the term will also be more expensive than it would be for a repayment mortgage. This is because the interest is calculated on the original loan amount each month rather than a decreasing amount.
Pros and cons of interest-only and repayment mortgages
There are pros and cons to consider for each type of mortgage, as detailed below.
The advantages of a repayment mortgage
- The interest payable decreases over the term as the balance of the loan decreases. This makes it cheaper overall than an interest-only mortgage.
- You’ll have access to better deals down the line as you repay more of the loan and increase the equity in your property.
- You’ll own your property outright at the end of the term.
The disadvantages of a repayment mortgage
- The monthly payments are higher than those for an interest-only mortgage.
- Only small amounts of your loan will be repaid during the first few years.
The advantages of an interest-only mortgage
- You benefit from cheaper monthly payments than with a repayment mortgage.
- The lower payments mean that more disposable income is available to you.
- You have more control over your investments, allowing you to choose your preferred way of saving to repay the loan.
- If the investment method you choose performs better than expected, you may be lucky enough to earn a profit after your loan has been repaid.
- Your lender may allow you to make occasional payments towards the loan. This reduces the amount to be repaid at the end of the term.
The disadvantages of an interest-only mortgage
- You don’t repay any of the loan amount each month, only the interest. This means that the original loan amount still has to be repaid when the term ends.
- It costs more overall as the interest is calculated on the full loan amount each month.
- You need a repayment plan for the loan, which must be approved by the lender.
- There’s a risk that the investment method you choose for your repayment plan may underperform. This leaves you with a shortfall to repay the loan.
- Not all lenders offer interest-only mortgages due to the higher level of risk compared with repayment mortgages.
- Lenders that offer interest-only mortgages usually ask for a higher deposit to compensate for the increased risk.
Can you switch from one mortgage type to the other?
You can switch from an interest-only mortgage to a repayment deal or vice versa. If you wish to change from an interest-only option to a repayment one, you’ll need to meet the affordability criteria for the higher monthly payments. This is a popular choice when lower payments are needed at the start of the mortgage term using an interest-only deal but then a better financial position is reached later on, enabling higher payments to be made, which can then start to repay the loan.
To change from a repayment option to an interest-only one, you need to prove to the lender that you can repay the loan at the end of the term. This option is worth considering if you’re struggling to maintain your monthly mortgage payments and need to lower them. Just bear in mind that you’ll no longer be repaying any of the loan balance. The Mortgage Charter allows for a temporary switch to an interest-only deal. This gives you a bit of breathing space with your finances in the current climate.
Is there a compromise between the two?
A part and part mortgage is a flexible option that combines the elements of an interest-only and a repayment mortgage. A smaller amount of the loan is repaid each month than with a repayment mortgage and you pay the interest on top. This means that you benefit from lower monthly payments but you’ll still have an outstanding loan balance to repay at the end of the mortgage term. When applying for a part and part mortgage, you need to provide the lender with a repayment plan, just as you would for an interest-only mortgage.
Should you opt for an interest-only or repayment mortgage?
Which option is best for you depends on your circumstances. A repayment mortgage, however, is usually considered to be the best choice. This is because you’ll own your property outright at the end of the mortgage term. As well as that, even though your monthly payments will be higher, the overall mortgage will be cheaper as the interest is calculated on the decreasing loan balance throughout the term.
If you’re buying an investment property, however, and intend to sell it in the future, an interest-only mortgage is a good choice. For example, if you’ve invested in a buy-to-let property in Pimlico, the lower monthly payments will help with your cash flow.
A temporary switch to an interest-only mortgage can also help to relieve the financial pressure if you already have a repayment mortgage for your home in Bexley but are struggling with your payments.
Our expert mortgage brokers can help you to decide
To help you make the right decision, give our mortgage brokers a call on 01322 907 000. They can discuss your circumstances and advise you on the differences between the two mortgage types in detail. Having checked your eligibility and affordability, they can quickly ascertain the type that’s best suited to your situation. When you’re ready, they can compare the mortgage deals across the board, looking for the best rates and terms to meet your needs, whether you’ve settled on having an interest-only or a repayment mortgage.