Interest-only Vs Repayment Mortgages

There are generally two methods of repaying the amount you have borrowed from your Mortgage lender- the “repayment” and “Interest-only” option. Or at least, most borrowers usually opt for one or the other.

Repayment Mortgage:

With this option your monthly payments gradually pay off the amount you borrowed, as well as paying the interest on the loan. If you stick to every payment, you would have paid off the loan at the end of the agreed Mortgage term (usually 25yrs).

Monthly repaymentss will cost more on a monthly basis compared to an interest-only policy, because the borrower is paying interest on the loan and reducing the debt each month.

Interest-only Mortgage:

Your monthly payments will NOT pay off any of the capital. So whatever you borrowed will have to be paid back at the end of the mortgage term.

Interest-only mortgages tend to be more flexible than repayment mortgages because most lenders allow you to make overpayments with Interest-only policies. So, for example, with repayment policies you have to make a set payment of £800pcm on a £150k mortgage (some lenders usually allow lump payments to reduce the outstanding balance further). For the same loan amount, the interest-only policy may require you to make a payment of £600pcm, with the option of making overpayments.

So in theory, you can pay £800pcm on an interest-only mortgage and reduce just as much debt as the repayment policy. But the beauty is that when the financial times get tough, you can go back to paying £600pcm, which is something you can’t do so easily with a repayment policy. That’s why interest-only mortgages are considered to be more flexible.

However, the reality is, many borrowers, particularly landlords, never make repayments, they just continue paying the interest, without actually reducing the debt. Why? Because they’re relying on house prices to increase (history dictates that they always eventually do), so when they sell in the future, that’s when they’ll make their money. In the mean time, borrowers continue making the lower interest-only payments, and the smarter and more organised borrowers, remortgage when it makes sense to benefit from better rates.

Final point

While interest-only mortgages may sound like the better option because of the flexibility, it’s important to note that it’s not always the most sensible option.

With a repayment mortgage the borrower is required to reduce the equity each month, it isn’t optional; so the borrower will eventually clear the debt (assuming all the payments are made), or at least reduce the debt. By reducing debt, equity is gained- that’s a key point.

Reducing the capital with an interest-only mortgage is optional, so it’s not always done. In fact, most borrowers rarely make overpayments because they’d rather pay less so they can spend a little extra on life’s luxuries. While that sounds like a great option, it can be extremely risky if house prices drop. Why? Imagine you purchased a house for £100k on a 100% mortgage and make no overpayments. Then out of nowhere, the market takes a turn for the worst and house prices drop by 5%. You’re suddenly left with a property worth £95k, but paying off a mortgage of &pound100k. That’s what is known as ‘negative equity’.

With a repayment mortgage you’re more unlikely to be hit by negative equity in the long run if the market takes a turn for the worst (i.e. house prices crash), because each month you increase equity when reducing the debt.

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1 Comments- Join The Conversation...

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Bridget mc Elwee 17th May, 2017 @ 14:30

Good afternoon Im wondering if theres any help out there for me to be able to buy my house im on dla long term sick and at christmas our landlord of 13 yrs lost here to the bank :(

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