Mortgages: Repayment-vs-Interest Only

How you repay your mortgage can be as important as the interest rate you borrow at. But do you go for the security of a repayment mortgage or are you willing to accept the long-term risks of an interest-only mortgage? We weigh up both options for you.

When thinking about a mortgage, one of the things you first need to consider is how you are going to pay back the capital that you borrow.

The two main options currently available to you are: repayment mortgages or interest-only mortgages.

What are they?

Repayment:
Repayment mortgages are many people’s preferred choice. They work by paying off an even portion of both the interest and the capital amount every month. The amount you pay off is calculated so that by the end of your mortgage’s term, say 25 years, the capital amount will be paid off in full and your house will belong to you.

Interest-only:
As the name implies, taking out an interest-only mortgage means that you will only be paying off the interest on your mortgage each month - none of the capital. The idea is that you invest the money that you save by making lower monthly repayments in a ‘repayment vehicle’, such as ISAs, Investment Funds or Pensions Plans. You then use the funds from your repayment vehicle to pay off the entire mortgage balance at the end of its term.

Risky business

Does the idea of low monthly payments sound appealing or is financial security more important for you? Before you rush to any decision, let’s first look at the advantages and disadvantage of both mortgage options.

Interest-only mortgages

Advantages:

• Lower monthly payments could make this a cheaper/more affordable way to get on the property ladder.

• If your savings or investments do well then you could end up with lump sum at the end of your mortgage as well as owning your house. A way of minimising risk is by choosing a fund that performs consistently in the long-term, rather than high-risk/high-return kind of investments.
• You get to decide when to start paying into an investment vehicle. This could free up your cash to spend on renovating your new property or even starting a family.

Disadvantages:

• You still owe 100% of your mortgage when you get to the end of the term.
• More complicated to operate than repayment mortgages - not only will you have to pick the correct investment vehicle, but also monitor its performance over the term of the mortgage.
• You are essentially gambling that the returns from your investment vehicle will be sufficient to cover the capital amount - low interest rates or market fluctuations could mean a lower than expected return from your investment vehicle (remember that if you can’t repay the capital amount when your mortgage ends you could lose your house).
• Because it is up to you to arrange an investment vehicle there is a temptation to spend your cash instead of saving it - again you could find yourself facing a huge repayment at the end with no means of paying it.
• Interest rates tend not be as favourable as those for repayment mortgages - if interest rates rise it could force your monthly payments higher than expected, leaving you with less to save in your investment vehicle.
• It’s no longer taken as granted that your property will increase in value over time - this means that you shouldn’t rely on a rise in house prices to pay off your debt at the end.
• Require smaller deposits which can make it easier for you to fall into negative equity if house prices fall.
• Now becoming more difficult to take out, with some banks no longer offering them to customers at all - those that are still offering them are requiring customers to put down bigger deposits and restrict the amount of money that you can borrow.

Repayment mortgages

Advantages:

• Safer and more straight forward to run than interest-only mortgages.
• If you make all of your payments then it’s guaranteed that your mortgage will be repaid in full by the end its term.
• Less risky than an interest-only mortgage which is subject to vagaries of market performance in order to pay it off.
• You pay back less over the whole term of your mortgage than with a interest-only mortgage as the debt is decreasing each month.

Disadvantages:

• Higher monthly repayments as you're repaying a proportion of the capital plus interest each month.
• The old saying that without risk, there’s no reward means that by going for the ‘safer’ option there’s no possibility of you benefiting from your investment vehicle performing well and leaving you with a ‘golden egg’.
• In the early years of your repayment mortgage you will find that you are only paying off the interest and not the debt (this means that if you want to pay your mortgage off early or move house then the majority of your debt will still be outstanding).

Tortoise or hare?

Which type of mortgage is best for you boils down to a simple question: are you willing to accept the risk that comes with an interest-only mortgage in order to reap any possible benefits?

If you’re itching to get on the property ladder as cheaply as possible then an interest-only mortgage can look appealing to a first-time buyer. Likewise if you are confident in your ability to operate a profitable investment vehicle or you have the finances to cover any shortfalls if your investment vehicle doesn’t perform as expected - then an interest-only mortgage could be for you. They also appeal to buy-to-let investors who can claim back tax on mortgage interest and also use their spare cash to renovate their property.

If you do take out an interest-only mortgage, it does not mean that you are stuck with it for the full term. Although there will be a cost involved, it is possible switch to a repayment mortgage and vice-versa if you are struggling to meet your monthly payments. You can also try to reduce the risk by going for a part repayment, part interest-only mortgage.

Of course, many people are rightly wary of using a risk-based investment to secure their home – especially in the light of the recent worldwide financial turmoil. When you consider the consequences of failing to pay off the capital amount from your interest-only mortgage, it is a risk many of us wouldn’t be willing to take.

As in the tale of the Tortoise and the Hare: slow and steady may take you longer to get to your destination, but with a repayment mortgage you are at least guaranteed to get there!