Interest-only Vs Repayment Mortgages

13 Jan 2007

There are two methods of repaying the amount you have borrowed from your Mortgage lender- the “repayment” option, and the “Interest-only” option.

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).

Repayment mortgages will cost the borrower more on a monthly basis than if they were on a interest-only policy because the borrower is paying interest on the loan and reducing the mortgage 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). With the same amount of mortgage, 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 a lot more flexible.

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. 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 called negative equity.

With a repayment mortgage you’re more unlikely to hit negative equity in the long run because each month you increase equity by reducing debt.

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