There are two main mortgage types – repayment and interest only. Most people buying a home are not doing so with an interest only mortgage – they are using a repayment mortgage instead. Why is that and are they making the right decision by doing so?
This blog looks at the nature, characteristics, pros and cons of an interest only mortgage.
If you are looking to take out a mortgage, should you opt for interest only? If you have an interest only mortgage now, should you be looking to switch to a repayment mortgage?
The answers will ultimately depend on your personal circumstances as assessed by an independent mortgage adviser.
However, here are some of the main factors to bear in mind when considering an interest only mortgage…
1. Nature of a mortgage
A mortgage is basically a loan which is secured on a property you own, be it your home or an investment property such as a buy to let unit.
The advantage to the lender is that they have the opportunity to sell the property (“repossession”) and recover the amount they have lent to you in the event of payment default.
The money is lent to you for a specific number of years – referred to as the mortgage term – typically 25 or 30 years; but longer or shorter terms are of course possible taking into account your age, circumstances and preferences.
The interest rate on your loan may be fixed or variable for the whole term or part of it.
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 certainty or control.
When you need to sell your property, you must pay off or redeem the mortgage.
2. Interest only mortgage
With an interest only mortgage, you make only interest payments each month; the capital is not repaid until the end of the term.
That means you must have plans in place to repay the capital at the end of the term; that is done by what is called a “repayment vehicle” such as a pension or savings.
In contrast, the monthly payment for a repayment mortgage comprises both an interest and a capital element. Each month you repay interest as well as a part of the capital amount borrowed.
In the early years of the term your payment is mainly interest, but it becomes mainly capital in the later years.
By the end of the term, the capital is fully repaid, leaving your property entirely mortgage free. No repayment vehicle is required.
With an interest only mortgage, as you are not reducing the capital debt each month, you end up paying more in interest overall.
The cost of a mortgage of £160,000 at 4% interest rate:
3. Advantages of an interest only mortgage
The main advantages of an interest only mortgage over a repayment mortgage are:
- Lower monthly payments; cheaper to run
- Flexibility in having a choice as to how to deal with the capital due 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 such a strategy is not risk free).
The cheaper cost means that you may be able to borrow more than you could with a repayment mortgage, thereby affording higher value properties which may otherwise be beyond you.
4. Disadvantages of an interest only mortgage
The main disadvantages of an interest only mortgage compared to a repayment mortgage are:
- None of the capital is being paid back each month; interest is paid on a non-decreasing capital balance and this results in more interest being repaid than with a repayment mortgage, where interest is paid on a reducing capital balance
- Arrangements have to be made to repay the capital at the end of the mortgage
- If no or inadequate arrangements are made, the borrower will be obliged to sell the property and move out
- The borrower may be compelled to sell at a time not to their advantage, making a loss on the sale or not maximising their profit.
Interest only mortgages may be a mortgage timebomb.
Government figures suggest one in five of outstanding mortgages is interest only.
Many borrowers with interest only mortgages may find it impossible to repay the capital at the end of their mortgage term and there is a possibility that large numbers were mis-sold interest only mortgages.
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5. Opting for an interest only mortgage
Before deciding on an interest only mortgage, you should assess what is important to you – both in the short term and the long term.
You need to decide what is more important to you overall.
Your preferences will determine your priorities, which in turn will determine your choices.
If your primary objective is to keep your monthly payments as low as possible throughout, interest only will be preferable.
If your main goal is to be mortgage free at the end of your mortgage, without having to use your savings, investments or pensions to clear the mortgage debt, a repayment mortgage is likely to be your best choice.
It does not have to be one or the other. As a first time buyer on a tight budget, you could decide to favour interest only for the first few years of your ownership, changing to a repayment mortgage later on – either with the same lender or a new one.
Further there are mortgage products which offer part repayment and part interest only.
As repayment mortgages pose fewer financial risks for lenders, the preference of home lenders at the present time is for borrowers to take out repayment mortgages.
The majority of home mortgages available and taken out are of the repayment kind. You may therefore find it easier to secure a home loan if your preference is a repayment mortgage.
With buy to let lenders, interest only mortgages are the norm and being cheaper enable investors to maximise rental return if that is their primary strategy.
However, if you are an investor looking to maximise long term capital growth, ending up mortgage-free, repayment mortgages may more suit your purposes.
Match up repayment and interest only mortgages:
Interest only mortgages may be appropriate for you if:
- You need to stretch your borrowing in order to secure the property you reasonably want
- Your income, earnings or profits are low or unpredictable giving you a low cashflow, regularly putting you at risk of mortgage affordability issues, requiring you to keep your mortgage overhead as low as possible
- You already have or will have in place an adequate repayment vehicle, such as a legacy, which will enable you to clear the mortgage debt at the end of the term without any bother.
In the long term, for most buyers, repayment mortgages are preferable in that they are likely to leave them richer at the end of their mortgage term, as well as cost them less overall.
Remember that there are other (less common) mortgage types apart from repayment and interest only – 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.
Always consult an independent mortgage broker before choosing a mortgage.
Do you have a mortgage now and what type is it? Why did you go for that type and do you have any regrets? Please leave your comments below.
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Rebel Property Coach
My website is: www.rebelpropertycoach.com