Should you get an interest only or repayment mortgage?

What is a repayment mortgage? 

With a repayment mortgage, your monthly repayments are split into two parts: one part pays off the interest owed on your original loan, the second part goes towards reducing the loan amount. 

The amount you pay each month is calculated to pay off the total amount owed by the end of the mortgage term, which is usually around 25 years. 

Once you reach the end of the term, you will own your property outright.

How does a repayment mortgage work?

Each payment you make towards a repayment mortgage will make a dent in the amount you borrowed to buy your property. 

But for the first few years, the proportion that goes towards the interest will be much greater than the amount that goes towards clearing your debt.

Over time, this changes because the interest owed decreases in line with the size of the loan.

In the last few years, the lion’s share of your payments should therefore go towards paying off your remaining debt.

If you have some spare cash available, you may be able to pay off your debt more quickly by increasing your payments by, say, £100 or £200 each month. 

You can also often reduce the cost of your repayment mortgage by switching to a deal with a lower fixed- or variable-interest rate.

What is an interest only mortgage? 

With an interest-only mortgage, your monthly repayments only cover the interest on your mortgage.

The amount you have to pay out each month is lower as a result. But the amount you owe your mortgage lender stays the same.

So if you borrow £200,000, you’ll have to find £200,000 to clear your debt at the end of the mortgage term, again usually around 25 years. 

As a result, most lenders now require evidence of a repayment plan, as well as a substantial deposit, to consider you for an interest-only deal - unless you are applying for a buy-to-let interest-only mortgage.

How does an interest-only mortgage work?

As the monthly payments on interest-only mortgages cover just the interest owed, they can often be hundreds of pounds cheaper than those for a repayment mortgage for the same amount.

On a 25-year, £200,000 loan with an interest rate of 3%, interest-only payments would be just £500, compared to nearly £950 with a repayment mortgage.

Unless you plan to sell the property at the end of the mortgage term, the idea is that you save or invest the difference into a repayment plan to ensure you have the cash to pay off your original loan amount.

Not everyone manages to do this, though. So your lender may want to check your repayment plan is on track at various points throughout the mortgage term.

What happens when my interest-only mortgage ends?

When your interest-only mortgage ends, you will need to pay off the original loan amount in one go. 

Ways to do this include:

• Withdrawing the required amount from your savings

• Selling investments such as stocks and shares

• Drawing down a lump sum from your pension fund

• Selling the property (hopefully for a profit)

• Taking out another mortgage (repayment or interest-only)

If you are concerned about being able to repay your mortgage on the given date, you may also be able to negotiate with your lender to extend the term. 

Which mortgage type is most suitable for me?

For most people buying a home to live in, a repayment mortgage is usually the more cost-effective option. That’s because you gradually pay off both the loan and the interest, so you’ll own your home outright by the end of the term.

Because of the risks involved, many lenders now only offer residential interest-only mortgages to borrowers with high incomes and large deposits, typically at least 50% of the property’s value.

Interest-only mortgages are more common in the buy-to-let mortgage market, where landlords plan to sell the property later to repay the loan.

If you do qualify for a residential interest-only deal, it could help reduce your monthly payments in the short term. This might be useful if you need spare cash early on - for example, to fund home improvements that could boost your property’s value.

Can you switch between interest-only and repayment mortgages

Yes, you can switch from a repayment mortgage to an interest-only mortgage or from an interest-only mortgage to a repayment deal.

However, switching from interest-only to repayment will mean having to prove you can afford the higher monthly payments.

Switching from a repayment deal to an interest-only mortgage can also be complicated and involves showing the lender your plan to pay off the loan at the end of the term.