Whether you’re buying your first home or remortgaging, you may be wondering whether you should get an interest-only mortgage or a repayment mortgage. Each option carries its own set of benefits and drawbacks, and the choice you make could have a massive influence on your monthly payments, financial flexibility, and long-term financial situation. Although interest-only mortgages have become less common in the UK since the financial crisis in 2008, they are still available and could be the right choice in certain situations.
Whether you’re looking to get a new mortgage or switch to a new deal, understanding the key differences between interest-only mortgages and repayment mortgages is crucial for making an informed decision that aligns with your budget and long-term goals. In this guide, we’ll explain what each type of mortgage is, how they compare with each other, and who they are suitable for.
What is ‘Capital’ and ‘Interest’ on a Mortgage?
Before diving into the differences between interest-only mortgages and repayment mortgages, there are two terms you need to understand. The ‘capital’ on a mortgage refers to the original amount of money you borrowed from the lender to purchase your property. The ‘capital balance’ or ‘remaining balance’ is the amount of money you borrowed minus any amount you’ve paid off. For example, if you borrow £300k, your capital is £300k. If you then repay £20k as a lump sum or as smaller monthly repayments, your remaining balance would be £280k. However, this isn’t the total amount you owe the lender, as you’ll also need to pay interest on the amount you borrow.
‘Interest’ on a mortgage is essentially a charge or fee you pay to the lender for borrowing money to buy a property. You can think of it as a kind of rent you pay on the borrowed money until it’s fully repaid. It’s usually calculated as a percentage of the remaining balance of your mortgage, which means the more capital you pay off, the less interest you’ll have to pay month to month.
What is an Interest-only Mortgage?
An interest-only mortgage is a type of home loan where you only pay back the interest month to month but not the capital itself. The term of an interest-only mortgage can vary depending on various factors such as your age and affordability, but you may be able to remortgage multiple times within the term to secure new interest rates. At the end of your full mortgage term, you’ll still owe the lender the original amount of money you borrowed.
How an Interest-only Mortgage Works in Three Steps:
- Borrow the money. You borrow the amount of money you need to buy a property.
- Pay the interest. You pay interest on the amount you borrowed on a monthly basis.
- Repay the capital. At the end of the mortgage, you repay the original amount you borrowed.
How Do I Repay the Capital on an Interest-only Mortgage?
How you plan to repay the capital at the end of your mortgage term is often referred to as a ‘repayment vehicle’. Common repayment vehicles include pensions, savings accounts, cash ISAs, bonds, stocks and shares ISAs, or a mix of these. You may also choose to sell the property to repay the capital, which is a common option for Buy To Let properties. In fact, selling the property can also be used for regular residential interest-only mortgages, but there are rules in place to ensure the borrower has sufficient equity to downsize to a suitable home in the future. Another option, providing you qualify, is to remortgage onto a new interest-only, repayment, or RIO mortgage. To learn more about RIO mortgages, please read our guide, ‘What Is A Retirement Interest-only (RIO) Mortgage?’
What is a Repayment Mortgage?
A repayment mortgage is a type of home loan where you pay back the interest and the capital month to month. This is currently the most popular type of mortgage in the UK. The term for a repayment mortgage can vary depending on your age and affordability, but you may be able to remortgage multiple times within the term to reduce the amount of interest you pay overall. At the end of your full mortgage term, you should have completely repaid both the interest on the money you borrowed and the capital itself – meaning you’ll own 100% of the equity in your home and you won’t owe the lender anything.
How a Repayment Mortgage Works in Three Steps:
- Borrow the money. You borrow the amount of money you need to buy a property.
- Pay the interest & capital. You pay interest on the amount you borrowed and a small part of the capital each month.
- Own the property debt-free. At the end of the mortgage, you would have repaid both the interest and the capital completely.
What is the Difference Between an Interest-only Mortgage and a Repayment Mortgage?
In terms of borrowing the money you need to purchase a home, both interest-only and repayment mortgages work in a similar way. However, you may be able to borrow more with an interest-only mortgage in some circumstances, but equally, you’ll typically need a larger deposit as lenders see interest-only mortgages as higher risk.
Where interest-only and repayment mortgages differ the most is in the way they are repaid. To recap, with an interest-only mortgage, you only repay the interest on a monthly basis, and then the full capital is owed at the end of your mortgage term. However, with a repayment mortgage, you repay the interest and the capital on a monthly basis, and providing you keep up with your payments, you’ll owe nothing at the end of the mortgage term.
This means that one of the most noticeable differences is that your monthly repayments will be considerably lower on an interest-only mortgage. But on the flip side, you won’t be increasing the amount of equity you own and therefore you’ll have to plan for a large lump sum repayment at the end of your mortgage term.
Let’s delve a little deeper and look at the benefits and drawbacks of interest-only and repayment mortgages.
Benefits of Interest-only Mortgages
- Lower monthly payments. This can be helpful if you’re on a tight budget or need to free up cash for other expenses.
- More flexibility. You can use the extra money you would have been paying on a repayment mortgage to invest, put towards other debts, or improve your lifestyle.
Drawbacks of Interest-only Mortgages
- You don’t build equity. Because you’re not paying off the capital, you won’t build equity in your home as quickly as you would with a repayment mortgage. This means you could be at risk of negative equity if house prices fall.
- You’ll need to plan for a lump sum repayment. You need to have a plan for how you will repay the capital at the end of the mortgage. This could be a challenge if you don’t have a reliable source of income.
- Higher total interest costs. Over the life of the loan, you will pay more in interest with an interest-only mortgage than you would with a repayment mortgage. This is because you’ll always be paying interest on the full amount you borrowed.
Benefits of Repayment Mortgages
- You’ll build equity. With each payment, you own more and more of your home, increasing your equity and financial security. You’ll fully own your home at the end of the mortgage term.
- You’ll pay less interest overall. As you pay off more of the capital, the amount of interest you owe each month will gradually decrease.
- You may qualify for better deals. As you pay off more of the capital, and your equity increases, you may qualify for better interest rates.
- Peace of mind. Knowing that you’re gradually paying off your mortgage and that you won’t have to pay a lump sum at the end to keep your home can give you peace of mind.
Drawbacks of Repayment Mortgages
- Higher monthly payments. Compared to an interest-only mortgage, your monthly payments will be higher because you’re paying off both the interest and the capital.
- Less flexibility. You won’t have as much flexibility with your money because your monthly payments take up more of your income.
- You won’t pay much of the capital at first. In the early years, you’ll be paying a relatively small amount of capital off compared to interest.
Can I Switch from a Repayment Mortgage to an Interest-only Mortgage?
Depending on your circumstances, you may be able to switch your repayment mortgage to an interest-only mortgage. If you do this before the end of a fixed-rate period, you may have to pay an Early Repayment Charge (ERC). To learn more about ERCs, please read our guide, ‘What is an Early Repayment Charge and When Do I Have to Pay It?’
Another thing to bear in mind is that interest-only mortgages can be more difficult to qualify for. You may need a much larger deposit (or a larger amount of equity) than if you were applying for a repayment mortgage. This is because lenders see these products as being higher risk. You may also need to prove to the lender that you’ll be able to repay the remaining capital at the end of the mortgage term.
Switching to an interest-only mortgage using the Mortgage Charter
As of the time of writing, there is a Government scheme in place in the UK that allows mortgage holders to temporarily switch to an interest-only mortgage for six months. At the end of the six months, you’ll automatically revert to your previous repayment mortgage, but your monthly repayments may be slightly higher to make up for the six months you’ve missed. This scheme can be useful for people who are struggling to afford their mortgage in the short term – allowing them some respite without affecting their credit score. This scheme is called the Mortgage Charter and you can read more about it in our article, Should I Extend My Mortgage Term or Switch to Interest Only?
Can I Pay off the Capital on an Interest-only Mortgage?
Most lenders allow you to pay off capital on an interest-only mortgage up to a maximum amount each year. This maximum is usually 10% of your capital, but some lenders may allow more. Going over your lender’s annual overpayment threshold could mean you have to pay an Early Repayment Charge. [add link once blog is published] It’s important to check your contract to see whether you are allowed to make overpayments on your interest-only mortgage and by how much. If you are, and you can afford to, this can be a good way of reducing the overall cost of your mortgage by decreasing the amount of interest you pay over the long term.
Is an Interest-only Mortgage Suitable for Me?
Deciding whether an interest-only mortgage is suitable for you requires careful consideration of your individual circumstances and financial goals. While they offer some potential benefits, they also come with significant drawbacks that may not align with your situation and your future plans. It’s also harder to get an interest-only mortgage in the UK than it once was, so you’ll need to be sure that you’ll be accepted, otherwise your credit score could be damaged.
In general, interest-only mortgages in the UK are mostly taken out by Buy To Let investors and older homeowners, but that doesn’t mean other people can’t get one. If you want to find out if an interest-only mortgage is right for you, how much you could borrow, and what deals you qualify for, please book a chat with one of our friendly mortgage advisors today.
Is a Repayment Mortgage Suitable for Me?
Repayment mortgages are by far the most common type of mortgage in the UK, especially for First Time Buyers, home movers, and mortgages for primary residences. Owning one’s home mortgage-free is a goal for many homeowners due to the financial security it can offer. Repayment mortgages allow the borrower to gradually own more equity in their home over the course of the mortgage term, providing a more structured and secure route to a debt-free home. In general, repayment mortgages are also easier to be approved for, which is another attractive feature for borrowers. To find out if a repayment mortgage is right for you, how much you could borrow, and what deals are available to you, please book a chat with one of our mortgage advisors today.
The Bottom Line
When paying monthly mortgage payments to a lender, there are essentially two separate payments you might be making. One payment might be to repay some of the initial money you borrowed (known as the capital) and one might be the interest on the money you borrowed. If you take out an interest-only mortgage, you only pay the interest month to month, and then you’ll need to pay back the capital as a lump sum at the end of the mortgage term. With a repayment mortgage, you pay both the interest and capital off each month, meaning you fully own the home at the end of the mortgage term.
Whether you should get an interest-only or repayment mortgage depends on your situation and goals. Interest-only mortgages are more common for Buy To Let properties and for older homeowners, but they may be suitable for other people in certain circumstances. Repayment mortgages are more common for First Time Buyers, home moves, and people remortgaging their primary residence. If you’re unsure whether to get an interest-only mortgage or a repayment mortgage, please book a chat with one of our friendly advisors today.
At Michael Usher Mortgage Services, we’ve been helping our local community for over 30 years! We’re not affiliated with any particular lender, so we can access a comprehensive range of mortgages from across the market to find a deal that suits your needs. We’ll guide you through the process and liaise with your lender, estate agent and solicitor to ensure your application goes as smoothly as possible, and we can also help to protect your mortgage with our FREE Insurance Service.
Talk to one of our friendly mortgage advisors for free to get going quickly. Our head office is on Frimley High Street, but we can also help you remotely via phone or video call if you’d prefer. We look forward to chatting with you!
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