There are generally two methods of repaying your mortgage, Repayment and Interest-only.
Both have their advantages and disadvantages, and one method will probably suit you better than the other.
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, your mortgage should be paid off 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.
Your monthly payments will NOT pay off any of the capital. So whatever you borrowed must be paid back at the end of the mortgage term (unless you remortgage to lengthen the loan period).
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.
Switching from Repayment to Interest-only mortgage types (or vice versa)
Most mortgage lenders allow borrowers to change between interest-only and repayment methods during an exiting policy. For example, if you have an existing mortgage policy that is interest-only, you can change it to repayment and visa versa.
The actual process of switching is pretty straightforward; it’s not like completely remortgaging. You’ll still keep your existing policy (same rates), however, your monthly payments will change.
You should check your terms and conditions or contact your lender’s customer service department just to clarify that you’re with in your rights to change the repayment method. However, from my experience, and as said, most lenders will accommodate the requested change.
Here’s a small extract from my old Northern Rock’s terms and conditions sheet. You should be looking for a clause which allows you to “change of repayment method”, as highlighted in red:
As you can see, there is a small £75 admin fee (the fee will vary depending on your lender).
Why switch from Interest-only to Repayment?
Many people switch from interest-only to repayment because, whereas they were only paying the interest on their mortgage, they now want to chip away at the outstanding balance each month.
Why switch from Repayment to Interest-only?
If the repayment method suddenly becomes too expensive for a borrower, for example, if there is a change in financial circumstances (e.g. drop in salary), then it’s common for borrowers to switch to interest-only.
By switching to interest-only, monthly mortgage payments will reduce significantly. Once the borrower gets into a better financial position, they can switch back to the repayment method of paying their mortgage.
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 balance of the debt 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 increases – 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 £100k. 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.
Disclaimer: I'm just a simple landlord blogger; I'm not qualified to give legal or financial advice. Any information I share is my opinion based on my personal experiences as an active landlord, and should never be contrued as legal or professional advice. For more information, please read my full disclaimer.