There are two main mortgage types – repayment and interest only. Most new borrowers are taking out repayment mortgages. Why is that and are they making the right decision by doing so?
This blog takes a brief look at the nature, characteristics, pros and cons of a repayment mortgage.
If you are looking to take out a mortgage, should your opt for interest only or repayment? If you have an interest only mortgage now, should you be looking to switch to a repayment type?
The answers will ultimately depend on your personal and financial circumstances and objectives as assessed by an independent mortgage adviser.
However, here are some of the main factors to bear in mind when considering a repayment 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 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. Repayment mortgage
With a repayment mortgage, your monthly payment comprises both an interest and a capital element. Each month you repay interest as well as part of the capital amount borrowed.
In contrast, you make only interest payments each month in the case of an interest only mortgage; the capital is not repaid until the end of the term.
In the early years of a repayment mortgage, 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.
The cost of a mortgage of £160,000 at 4% interest rate:
3. Advantages of a repayment mortgage
The main advantages of a repayment mortgage over an interest only mortgage are:
- You are paying back interest and capital each month
- You end up paying substantially less in interest over the term compared to an interest only mortgage
- You pay off the capital in full by the end of the term
- You don’t have to make separate arrangements for the capital to be paid off at the end of the term or to use your savings or pensions to clear the mortgage debt
- You end up with a mortgage-free property when your mortgage ends
- A mortgage-free property has a wide range of personal and financial benefits.
At the end of the mortgage you will have a mortgage-free property probably worth several times the price you paid for it.
4. Disadvantages of a repayment mortgage
The main disadvantages of a repayment mortgage compared to an interest only mortgage include:
- Your monthly payments are likely to be significantly greater, making your mortgage a bigger overhead
- The higher payments increase your risk of not being able to pay your monthly payments, increasing the risk of mortgage difficulties or proceedings.
You can guard against the risks by ensuring that you do not borrow more than you can afford and budget for a mortgage reserve to meet payments at times of financial difficulty.
Match up repayment and interest only mortgages:
5. Opting for a repayment mortgage
Before deciding on a repayment 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 main goal is to be mortgage-free at the end of your mortgage, without having to use your savings or pension to clear the mortgage debt, a repayment mortgage is likely to be your best choice.
If your concern is to keep your monthly payments as low as possible, interest only will be preferable.
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.
In terms of long term benefits, there seems little doubt that a repayment mortgage has the edge.
Since repayment mortgages pose fewer financial risks for lenders, the preference of 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.
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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.
With a repayment mortgage, you do not have to set up a repayment vehicle (such as savings or a pension) to pay the mortgage debt at the end of the term.
If the property is your home, you will be free to remain and will not be obliged to sell (perhaps at an inopportune time) and find alternative accommodation.
You will have the incalculable benefit of peace of mind.
You will also have a large, charge-free asset which you can use or leverage for a variety of personal, family or business purposes.
However repayment mortgages may not be suitable if your income is unpredictable with persistent cashflow shortages.
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?
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Rebel Property Coach
My website is: www.rebelpropertycoach.com