When you are buying a property there are two big choices facing you in terms of selecting the mortgage. Should you opt for an interest only mortgage or a repayment mortgage?
Which is best for you?
For many people the deal-breaker is cost. Typically interest only mortgages are cheaper in terms of monthly payments.
But with mortgages, cheap today is not necessarily best tomorrow,
1. Interest only mortgage
This is the type of mortgage where you do not pay back the sum borrowed, the capital, until the end of the mortgage term, which is typically 25 years but can be longer or shorter.
Each month you pay the interest on the loan. If the interest rate is variable, your payments will rise or fall from time to time according to the interest rate of your mortgage lender; which in turn follows the Bank of England’s base rate.
For peace of mind, you can fix the interest rate for all or part of your mortgage term.
If you opt for a variable rate you will be at the mercy of interest rate increases.
However, fixed rate loans tend to be more expensive than their variable rate counterparts.
2. Repayment mortgage
With a repayment mortgage, your monthly payment comprises both an interest and a capital element. In the early years of the mortgage term, your payment is mainly interest but it becomes mainly capital in the later years.
By the end of the term, you will have paid off the whole capital and will be mortgage-free.
By paying off part of the capital each month, you end up paying less interest compared to an interest only mortgage where you only pay back the capital at the end of the term.
If you go for a variable interest rate, the amount you pay each month will fluctuate in line with changes in the Bank of England’s base rate. You can opt for a fixed rate for greater financial control.
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3. Pros and cons interest only
The headline advantages of an interest only mortgage over a repayment mortgage include:
- Lower monthly payments; cheaper to run
- Flexibility in having a choice how to deal with the capital at the end of the term – you can save in various ways to clear the debt at that point or simply opt to sell your property and repay the debt from the proceeds (although this strategy is not risk free).
The headline disadvantages include:
- None of the capital is being paid back each month; interest is paid on a non-decreasing capital balance and this is more expensive than a repayment mortgage overall
- Risk of having to sell up and move out if the capital cannot be paid back at the end of the term.
If your household budget is tight, an interest only mortgage may be the best option for you, moneywise. As your financial position improves with time, you can always change to a repayment mortgage.
You can make long-term plans to pay off the capital by the time you get to the end of the term – for instance by relying on savings or your pension or selling an investment such as a BTL property.
As you are not repaying any of the mortgage debt each month, having an interest only mortgage puts you at greater risk of negative equity – the situation where the value of your property is less than the mortgage debt.
By not reducing the capital balance each month, you end up paying more in interest compared to a repayment mortgage.
Having an interest only mortgage without a realistic plan to pay off the capital can be a bit of a mortgage timebomb.
4. Pros and cons repayment
The main advantages of a repayment mortgage over an interest only mortgage include:
- You are reducing your debt to your mortgage lender each month so end up paying less in interest overall
- At the end of the mortgage you will have a mortgage-free property probably worth several times the price you paid for it.
Drawbacks of a repayment mortgage include:
- They are more expensive and a challenge in the early years of your mortgage when you are likely to be most stretched financially
- You do not start to pay off significant amounts of the capital until the later years of the term; in the early years you are mainly paying back interest.
Having a valuable mortgage free property in your later years is rewarding, comforting and gives you a range of financial benefits and lifestyle and family options.
You won’t face the disruption of having to move out of your home at the end of your mortgage term if you don’t want to do so.
On the other hand, because you only start to pay off capital in significant amounts towards the end of the term, you don’t get the full benefit of a repayment mortgage unless you stick with it.
If every time you move you take out a repayment mortgage but borrow a higher amount to buy a more expensive property, that may not be the most efficient way to become mortgage free.
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5. Not clear-cut
The decision whether to choose an interest only mortgage or a repayment mortgage is not always clear-cut.
Where you can only just afford a mortgage, interest only will be the practical choice – but such mortgages have potential drawbacks in the long term.
Repayment mortgages are more expensive initially and you don’t start to eat away the capital in earnest until the later years of your mortgage.
You are probably reducing the benefit of a repayment mortgage if, each time you move, you borrow more rather than less.
With an interest only mortgage, you can reduce the capital informally by making overpayments as an when you can afford to do so, subject to the terms and conditions of your mortgage.
You can start with interest only and remortgage to repayment as your monetary position improves on account of wage rise, promotion or greater profits.
You can hedge your bet by choosing a “part repayment and part interest mortgage” – in theory gaining the best of both worlds.
6. The importance of mortgage advice
Before deciding on the type of mortgage, it is highly recommended that you consult an independent mortgage adviser – ensuring that you find the mortgage most suited to your unique personal circumstances.
You should be aware that there are other mortgage types – notably offset mortgages which are very attractive if you have significant savings and want to offset them against your mortgage balance, reducing your monthly payments as a result.
Offset mortgages may be best for most borrowers; that is probably why lenders are not exactly falling over themselves to promote them.
What is your approach to mortgages? Do you want to be mortgage free the end of your mortgage? If so, are you taking the steps to achieve your goal? Please leave your comments below.
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Rebel Property Coach
My website is: www.rebelpropertycoach.com
Categories: 01 Finance