Repayment Vs Interest Only – Which is best for me?
Finding a house you love. Securing a great deal on it. Finally picking up the keys. These are the easy and fun parts of purchasing a new property. For the next 25 + years it will be all about how to pay the money back to the bank that made the whole thing possible. One of the first decisions you will need to make is repayment vs interest only.
Today we will cover:
What are the options – Repayment Vs Interest Only?
To start with there are only two main options when comparing repayment vs interest only which makes things a little simpler. Lets start with the most common option.
Repayment.
A repayment mortgage is currently the most common mortgage in the UK. Around 88% of mortgages are set up in this way. Each monthly repayment reduces the total balance of the mortgage remaining. The plan is that by the end of the term, all payments are up to date and the remaining balance reduces to zero. Congratulations, you now own your home.
A repayment mortgage is a fairly simple division between the total amount borrowed, and the total number of months the mortgage is to be repaid in.
Example:
- So for example, lets assume you were to borrow £300,000 interest free over 25 years (300 months). The monthly repayment would be £300,000 divided by 300 = £1,000 per month.
- However, it gets a little more complicated. The banks aren’t going to lend you all of that money for free.
- They will of course charge interest on the money used to purchase your home. Therefore, each monthly repayment made covers both the interest due alongside a smaller sum used to reduce the balance overall.
- Let’s amend the example above to take into account an interest rate of 5.00% being applied. Over the same term of 25 years (300 months), the monthly repayment would need to be £1,753.77 to make sure the balance is reduced to zero at the end of year 25. The total amount you would have paid back will be £526,131
It’s clear to see why everyone wants a low rate of interest on their mortgage. Firstly it determines what your disposable income will be on a month-to-month basis. Secondly, it influences your decision as to how long the term of the mortgage should be. Finally it sets out the total amount of money you will be paying to the bank for their initial investment in your house. Everyone wants this to be as low as possible.
How does the term of the mortgage change the monthly repayment?
When the bank charges interest on mortgage borrowing, it is compounded. If a term of 30 years is chosen (360 months) for the example above the results are different.
£300,000 divided by 360 months at an interest rate of 5% = £1,610.46 per month.
Over the entire 360 months the total amount you would pay back is £579,765. This consists of 5 extra years of interest due.
Therefore, by extending the mortgage term by 5 years, the monthly repayment has become cheaper by £143.31. However the total amount you will repay over 30 years is £53,634 higher than if you had chosen a 25 year term.
Below is an image of an amortisation table. This table breaks down each repayment into the interest element and how much is being reduced from the balance. You will notice that the amount of each monthly repayment dedicated to reducing the balance increases each time. This is because interest is recalculated on the remaining balance following each monthly repayment. As the balance reduces, so does the impact of the interest being charged.
Above – 25 year term repayment mortgage (£300,000 @ 5.00%)
Below – 30 year term repayment mortgage (£300,000 @ 5.00%)
Clearly opting for a shorter term is more beneficial and cost effective in the long run. Provided that the monthly repayments are affordable (and maintained), a repayment option will always guarantee to clear the debt in full over the term of the loan. This is great peace of mind.
Pro’s and Con’s of a repayment mortgage.
Positives
Guarantees to repay the mortgage in full over the term as long as repayments have been maintained. Useful when planning for retirement.
Easy to see how your balance is reducing and what level it will be at in the future.
No need for any secondary repayment plan.
Mortgage terms can be matched to fit a preferred monthly budget.
In most cases overpayments can be made to speed up balance repayment when interest rates are lower.
Negatives
Shorter terms can be prohibitively expensive on a monthly basis.
Banks may not lend as much over a shorter term and maximum terms are dependant on age.
The aim may not be to repay a mortgage in the short term. The property could be sold, or an upcoming lump sum may be used to clear a significant portion of the balance. In these cases chipping away at a balance slowly is not the main priority.
Extending a term to reduce the monthly repayment will see a gradual tapering off of its effectiveness as the term lengthens. So taking a 25 year term instead of a 20 year term will result in a greater overall difference in repayments than extending from 30 years to 35 would do.
Interest Only.
Unlike a capital repayment mortgage, an interest only mortgage is one where only the monthly interest amount is paid. None of the monthly repayment is used to reduce the capital balance. Therefore, your balance will remain the same and will not reduce unless additional overpayments are made.
As you are only repaying the interest due and not the capital balance, the monthly repayment will remain the same regardless of which mortgage term is chosen.
If you were to borrow £300,000 over a 25 year term at 5.00%. The monthly repayment would be £1,250 based on purely the interest element. This would also be the same monthly repayment over any other term.
The term itself is important as this determines the point in the future that the lender will demand full and final repayment of the remaining capital balance. So assume you were to choose a term of 10 years on a £300,000 interest only mortgage @ 5.00%. You would pay 120 months at £1,250 per month, and then the lender will ask for the final balance of £300,000 once the term has ended. If you don’t have the £300,000 to hand the lender are within their rights to repossess the property in order to cover their debt.
Repayment vehicles.
This leads us nicely on to one of the most important factors when considering an interest only mortgage.
The lender will want to know how you intend on covering the the remaining capital balance at the end of the term. To verify this, they will want you to have a suitable repayment vehicle in place. A repayment vehicle is a method of guaranteeing that enough money will be available on the day of demand.
Some of the more commonly accepted vehicles include; a lump sum saved from a pension or other investment, regular savings accrued over the term, the sale of other property or assets, selling the current house and downsizing etc.
Each lender will have their own rules regarding what is acceptable as a repayment vehicle. If it is not feasible to save the required amount over the timeframe agreed they can refuse the loan. Instead they will most likely only agree a capital repayment mortgage as in the first example.
It is your responsibility to ensure that the repayment vehicle remains on track to meet its purpose over the term. The cost of funding the repayment vehicle should be factored into monthly affordability calculations.
Reviewing your interest only repayment plans regularly is important. Potential shortfall can be highlighted early and remedial action can be taken. You can also switch back onto a normal capital and interest repayment mortgage if you prefer. However beware that the term available at that point may mean that your monthly repayments will be considerably higher. This is especially the case as you near retirement age.
Pro’s and Con’s of an interest only mortgage.
Positives
The monthly payment on the mortgage will be as low as possible because only the interest element is being covered. This could free up disposable income to use in other investments.
When interest rates are low, even large mortgages will cost very little each month. Lenders may offer a higher level of borrowing.
Can be useful in the short term if the main priority is keeping costs down and not repaying the debt. For example, a lump sum from a pension / investment is due soon, or if the property will be sold.
Many landlords choose to setup their mortgages on interest only becuase the net monthly income they receive will be maximised.
In most cases, overpayments can be made to chip away at the capital balance as and when.
Can be used as short term relief against high interest rates or cost of living pressure. Especially if there is a risk of failing to meet a capital and interest monthly payment. Temporarily switching from a repayment mortgage to an interest only one can relieve some day-to-day pressure on finances. However always speak to your lender about this as they will want you to catch back up in the future.
Negatives
There is always a risk that the repayment vehicle will not cover the debt at the end of the term. This means a higher risk of repossession.
Lenders have strict criteria surrounding repayment vehicles. They often want to see a minimum level of earned income. In addition to this they may want to assess the value and trend of savings and investments. A large amount of equity in the property is also a normal requirement.
As the mortgage balance remains unchanged, there is a greater chance of slipping into negative equity if there were to be house price crash.
Requires careful financial planning throughout the term to ensure that the repayment vehicle(s) remain on track. Repayment mortgage balances will reduce to zero. All you need to do is keep up the repayments.
Not every lender will offer an interest only mortgage. The best deals may not always be available as a result.
Part and Part option.
A hybrid solution is on offer although it is somewhat underused in the UK mortgage market. It can offer some of the key benefits of each method, but mitigate some of the risks.
Mortgage loans can be agreed on a part and part basis. This means that a portion of the amount borrowed will be taken as a regular repayment mortgage, with the rest being on interest only. How this is split is generally down to the lenders criteria and how much your repayment vehicle can cover, but 50/50 or 60/40 is fairly common.
Using our example of a £300,000 mortgage with a 25 year term and a 5.00% interest rate. By splitting the loan amount 50/50, effectively £150,000 is on a repayment basis and would be £876.89 per month. The remaining £150,000 would be on interest only and the cost would be £625. This gives us a grand total of £1,5011.89.
When comparing this to a full repayment mortgage at £1,753.77 or full interest only at £1,250 and you can see this fits somewhere in the middle.
The total monthly outgoing is lower so a little more disposable income available. Repayment vehicles only needs to cover half of the loan amount at £150,000 instead of the full £300,000. This means less to save for over the 25 year term. Downsizing will be easier due to the balance of the loan being £150,000 in 25 years.
Lenders can afford to relax their criteria due to their level of risk being reduced. Mainly due to the £150,000 on a repayment basis.
Many of the inherent risks remain the same and those listed above so still proceed with caution. However, this method can often be useful in cases where a balance needs to be struck.
Conclusion – Repayment vs Interest Only.
For most people, most of the time, a standard capital and interest repayment mortgage will be fine. It is a relatively safe option with few major drawbacks. If it is your first time mortgaging a house, this would probably be the recommended route.
However if you have a need for flexibility, ample equity, background investments, sound future financial planning, or if you want to free up some monthly capital to invest elsewhere then an interest only mortgage or part/part option may be worth a look. Just be aware of the risks.
Check out our remortgage guide along with a comparison between fixed and tracker mortgages for more info.
Post compiled by Grant Carpenter CeMAP, CeFA – 15 years of regulated mortgage advice.
Please note that the content listed within this post is purely for information purposes only and does not constitute advice.
