When it comes to mortgages, borrowers are faced with important decisions regarding their repayment options. Two common choices are repayment mortgages and interest-only mortgages. Understanding the key differences between these two types of mortgages is crucial for making an informed decision that aligns with your financial goals. In this guide, we will explore the distinct characteristics of repayment and interest-only mortgages, highlighting their advantages and disadvantages.
By delving into the various aspects of each option, you can gain the knowledge necessary to select the most suitable mortgage type for your unique circumstances.
With a repayment mortgage, you pay back both the principal amount borrowed and the interest charged on the loan over the agreed term.
With an interest-only mortgage, you only pay the interest charged on the loan, but not the principal amount borrowed. This means that at the end of the mortgage term, you will still owe the original amount borrowed.
Repayment mortgages have shorter terms, higher interest rates, and are suitable for those looking to own their home outright.
Interest-only mortgages have longer terms, lower rates, and are suitable for those planning to pay off the principal later.
Repayment mortgages offer predictable payment schedules, equity build-up, and lower interest charges.
Interest-only mortgages offer lower monthly payments, flexibility, and investment potential, but come with higher overall costs, no equity build-up, and higher risk.
Interest-only or repayment mortgage: What are the differences?
Repayment mortgages require monthly payments towards both interest and principal, while interest-only mortgages only require payment of the interest. Repayment mortgages have shorter terms but higher interest rates, whereas interest-only mortgages have longer terms but lower rates.
Repayment mortgages are best for those looking to own their home outright, while interest-only mortgages are suitable for those planning to pay off the principal later. Both types carry risks, including the inability to pay off the principal amount and financial strain from high monthly repayments. Let's look at them in more detail.
What is capital?
What is interest?
What is a repayment mortgage?
A repayment mortgage is the most traditional type of mortgage. When you take out this type of loan, you make monthly payments that gradually reduce the balance of the amount borrowed, as well as the interest charged on the loan. This means that at the end of your mortgage term, you will have fully paid off the entire amount borrowed, including the interest charges.
When you take out a repayment mortgage, your monthly payments are calculated based on the total amount borrowed, the interest rate charged, and the length of the mortgage term.
Early in the mortgage term, the majority of the payment is interest, and only a small amount is used to pay off the principal. However, as you make payments over time, the amount of interest charged decreases while the portion of the payment that goes towards paying off the principal gradually increases.
Here's an example breakdown of the costs for a 30-year repayment mortgage for £350,000 with an interest rate of 4%:
Amount paid monthly | Of which interest | Amount owed | |
|---|---|---|---|
Year 0 | £1,671 | £1,166 | £350,000 |
Year 1 | £1,671 | £1,152 | £342,218 |
Year 5 | £1,671 | £1,062 | £305,852 |
Year 10 | £1,671 | £881 | £251,783 |
Year 15 | £1,671 | £693 | £178,070 |
Year 20 | £1,671 | £491 | £87,082 |
Year 25 | £1,671 | £269 | £10,790 |
Year 30 | £1,671 | £0 | £0 |
Advantages and disadvantages of a repayment mortgage
- Predictable payment schedule – You can plan and budget easily, as you know exactly how much you will be paying each month for the duration of the mortgage term.
- Equity build-up – With each payment made towards a repayment mortgage, you are slowly owning a larger share of the property.
- Lower interest charges – Since you are paying the principal balance of the loan each month, you are also reducing the amount of interest charged on the outstanding balance.
- Higher monthly payments – Because you’re paying both principal and interest charges, the overall amount owed each month is higher.
- Less flexibility – Since the monthly payments for a repayment mortgage are fixed, there is less flexibility if you experience financial difficulties.
- Shorter terms – These come at a higher monthly amount to fully repay the loan in that time frame, which can make it harder for some borrowers to meet their monthly payment obligations.
What is an interest-only mortgage?
An interest-only mortgage is a type of mortgage where you only pay the interest charged on the loan each month, but not the principal amount borrowed. This means that at the end of the mortgage term, you will still owe the original amount borrowed.
With an interest-only mortgage, the amount of interest charged is calculated based on the outstanding balance and the interest rate charged by the lender. Interest-only mortgages are generally available for a longer term than repayment mortgages, which means that monthly payments are lower, but the overall cost of borrowing is higher.
To pay off the principal amount owed, you will need to have a plan to repay the loan, such as through selling the property, investment earnings, or other means of generating income.
Here's an example breakdown of the costs for a 30-year interest-only mortgage for £350,000 with an interest rate of 4%:
Amount paid monthly | Of which interest | Amount owed | |
|---|---|---|---|
Year 0 | £1,167 | £1,167 | £350,000 |
Year 1 | £1,167 | £1,167 | £350,000 |
Year 5 | £1,167 | £1,167 | £350,000 |
Year 10 | £1,167 | £1,167 | £350,000 |
Year 15 | £1,167 | £1,167 | £350,000 |
Year 20 | £1,167 | £1,167 | £350,000 |
Year 25 | £1,167 | £1,167 | £350,000 |
Year 30 | £1,167 | £1,167 | £350,000 |
Advantages and disadvantages of an interest-only mortgage
- Lower monthly payments – These can make interest-only mortgages can make it more suitable for some borrowers to maintain their monthly payments.
- Flexibility – Only needing to pay the interest charges each month, can make your debt more manageable if your financial circumstances change.
- Investment potential – Since you’re not using your monthly payments to pay down the principal amount borrowed, you may have more money available to invest in other areas.
- Higher overall cost – You will have to pay more in interest charges over the life of the loan, which can increase your overall cost of borrowing.
- No equity build-up – Since principal repayments are not made each month, you will only own the property at the end of the term when you’ll repay it.
- Higher risk – Unless you have a good financial plan in place to pay your property at the end of the loan’s term, you may be left with a significant debt that you are unable to pay off.
When is it better to have an interest-only over capital repayment mortgage?
While both repayment and interest-only mortgages have their advantages and disadvantages, there are certain situations where one may be more beneficial than the other. Here are some cases where interest-only mortgages may be a better option over repayment mortgages:
Investment properties – With lower monthly payments, investors may have more money available to invest in other areas, potentially generating more income than the amount charged in interest. Income generated through renting the property out can also be used to cover the monthly interest payments.
Higher risk tolerance – Since you are not paying off the principal amount borrowed, you can potentially invest the money into other financial opportunities that could generate higher returns. This can be a risky approach, but if successful, can result in higher profit margins.
Irregular income – With its lower monthly payments, an interest-only mortgage may be more feasible for self-employed individuals or those working on commission. This can help manage cash flow and provide flexibility when income is unpredictable.
Periods of high inflation – Since inflation can erode the value of the principal amount owed over time, with an interest-only mortgage, borrowers can use the excess funds to invest in other areas, potentially generating higher returns that can offset the impact of inflation.
Yes, you can switch from a repayment to an interest-only mortgage or vice versa. The process of switching between mortgages can vary depending on the lender and the type of mortgage. Generally, borrowers will need to apply for a new mortgage or a review and go through an approval process, the exact steps of which will vary based on the lender and what changes you're trying to make.
This can involve submitting financial information and undergoing a credit check (to ensure you can pay off the higher monthly payments of a repayment mortgage). Additionally, there may be fees associated with switching mortgages, such as arrangement, valuation, and legal charges.
