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Repayment or interest only mortgage?

a house made of twenty pound notesWe are so glad this perennial old chestnut has turned up. It allows us to answer the question with the provocative assertion that there is no such thing as an “interest only” mortgage! OK, then, more strictly speaking, there’s no such thing as an interest only loan. The mortgage itself might be interest only. But the capital element doesn’t just disappear. It’s repayable at the end of the mortgage term and you’ll need to be paying into a separate savings plan (an ISA or a pension plan, for example) from which you’ll eventually have to make that repayment.

And that’s the difference between the two types of mortgage, of course? With the straight forward, more “old fashioned” repayment mortgage, your monthly repayments contain an element of both interest and capital repayment (the proportion of interest to capital gradually declining as the amount of the outstanding loan diminishes over time). With it, comes the reassuring knowledge that when it comes to full term, you’ll have paid off the entire debt. Furthermore, if you want to shorten the life of the mortgage and reduce its cost, any increase in monthly repayments will go towards both the interest and capital elements of the loan. So, the repayment mortgage keeps the whole of the loan in one place, under one roof as it were, and tends to offer you greater flexibility in response to changing personal circumstances.

Such security and peace of mind comes at a price, with the monthly repayments tending to be greater than those on an interest only mortgage together with its associated capital savings plan. The repayment mortgage lender may also make it a condition that you take out a mortgage protection policy, which guarantees repayment of the outstanding loan in the event of the mortgagee’s death.

If the monthly commitment demanded by a repayment mortgage is too steep for you, then it’s certainly worth investigating an interest only mortgage and an associated investment or savings plan. Your monthly commitment is likely to be lower.

By paying less, however, you should be clear that you are also assuming a greater part of the longer-term risk. Like most of the risks on the financial markets, you can win or you can lose. In this instance, the investment or savings plan that you open in order to provide the capital repayment on the full term of am interest only mortgage could succeed very well and leave you not only with the wherewithal to repay the capital loan but also with a handsome cash bonus. On the other hand, if your investment scheme fails to deliver as promised, you could be left without enough to repay the capital loan and still owe money on the property even when the mortgage payments have finished.

There is one particular category of buyer, however, for whom the interest only mortgage is going to have a particular attraction. For the buyer who intends to let the property purchased – i.e. a prospective landlord – an interest only mortgage not only offers the benefit of cheaper repayment terms, but also potential tax advantages. An expenditure the landlord can offset against rental income is the interest he needs to pay on his loan. He cannot offset the capital element of his repayment mortgage, on which the interest element will be steadily declining over the years. It will be to his advantage, therefore, that the interest only mortgage offers a constant rate of interest, and a constant source of expenditure against which to offset rental income, throughout the life of the mortgage.

So, just to recap, a repayment mortgage can be great for people who

  • Want the peace of mind that at the end of the mortgage term, their debt, including interest, will be paid off in full

While an interest only mortgage may be suited for:

  • Landlords
  • People who cannot afford to pay off the interest and capital on the borrowing but having a suitable savings vehicle which will clear the capital at the end of the mortgage term

If you've got a mortgage in mind and want to know how much you'll be paying back each month, try our mortgage calculator tool.