When purchasing a property you first have to ask yourself a fairly crucial question; how am I going to pay for it? If, like the majority of us, you don’t have a rich relative waiting in the wings you’ll need to arrange a mortgage.
Believe it or not mortgages are quite straightforward. You simply borrow the amount of money required to complete your purchase from a lender of your choice and agree to repay this amount, with interest, over a set period of time.
There are, in principle, two methods available for repaying a mortgage – capital repayment and interest only. The key decision you need to make is which method is the right one for you and your circumstances.
What’s the difference between interest only and a repayment mortgage?
There are two elements to a mortgage – capital and interest. Capital is the money you need to buy your property and the interest is what a lender will charge you for borrowing the money. An interest only mortgage, effectively, keeps these elements separate for the entire term of the loan.
Your lender will only collect the interest payments on a regular basis (typically monthly) and leaves the method of repaying the capital down to you. This is a key difference between a repayment and interest only mortgage. There are lots of different repayment vehicles available to you, which will be discussed in more detail later in this article.
Whatever repayment vehicle you choose is up to you, however, you need to be confident that you will have enough to repay the capital amount in full by the end of the term. Be mindful that most lenders will insist on having a clear understanding as to how you intend to pay for the capital element before agreeing to an interest only mortgage.
Capital Repayment Mortgage
Whereas an interest only mortgage separates capital and interest, a capital repayment mortgage does the opposite. A repayment mortgage is regarded as the most conventional method for repaying a mortgage debt.
With a repayment mortgage you will make a monthly payment that consists of both capital and interest, therefore, the capital you borrow reduces gradually throughout the term. By the end, if all payments have been met, the capital will have been totally repaid and the lender will have no further interest in your property.
The ratio of interest to capital within each monthly payment varies throughout the term. Initially the interest element is highest before reducing as the capital element dwindles and this becomes the higher proportion of the two.
So, as you can see there are some key differences between interest only and repayment mortgages. To find out more about each repayment method make an enquiry and an expert can get in touch to give you some more details.
The benefits of a repayment mortgage
Peace of mind
Quite clearly the main benefit is peace of mind.
If you’re looking for complete assurance and a guarantee that your mortgage will be repaid in full by the end of the term then a repayment mortgage is what you’re looking for. All you need to concern yourself with is making sure those monthly payments are made on time and as agreed. It’s as simple as that.
Ability to keep payments low
There’s a great deal of flexibility when it comes to repayment mortgages also. If you’re a first time buyer and looking to get on the ladder with the lowest monthly payments, you should consider stretching your loan term as far as you can. Whilst most lenders offer 25-year terms as standard, some offer 30 years and a few even offer 35-40 year terms.
Lower deposit required
Another massive issue for first-time buyers is accruing a big enough deposit. Since lending criteria was tightened following the financial crash at the end of the last decade, most lenders are reluctant to lend over 85% of the value of a property. However, more recently, some lenders have relaxed their criteria and will lend up to 90% and in some instances 95%.
Higher loan-to-value mortgages using a repayment method are much more readily available than interest only. Most lenders will not accept any less than a 25% deposit for interest only mortgages, some will only take 40% and a few may request as much as 50%. Larger deposits can be a big disadvantage of interest only mortgages.
The benefits of an interest only mortgage
Despite a fair amount of adverse media coverage over the years, there are still a number of extremely valid reasons and circumstances where an interest only mortgage is the most viable option over a repayment mortgage.
Lower monthly payments
When weighing up the pros and cons of interest only mortgages, the first and most obvious benefit are the lower monthly payments as they only contain the interest element rather than a combination of interest and capital repayment.
The table below illustrates the difference in monthly payments between interest only and a repayment mortgage. The payments are based on borrowing £200,000 using the same 3% interest rate for both methods.
(TAR = Total Amount Repayable)
There’s quite a big difference between the monthly payments of each method. The interest only mortgage payment won’t change, as the capital element remains the same regardless of the term. However, this also means the total amount repayable will be higher.
Ability to repay quicker with a savings vehicle
As the next section will clarify, there are a whole host of repayment vehicles that can be used to cover the capital element of your interest only mortgage. You may already be in possession of such a vehicle at the time you’re looking to buy your property. In such circumstances it may well make more sense to use this vehicle as a means of capital repayment.
Most recently, a high number of borrowers have taken advantage of interest only mortgages on the basis that they will downsize their property when they retire. The equity from their existing property will be part used for a new, smaller, one and the remainder will pay off the outstanding capital.
Retirement interest only
These are pretty much the same as a standard interest only mortgage that lets you pay just the interest each month, without reducing the capital. The difference is that these loans don’t have a set end date. The loan is only redeemed should you sell, go into care or pass away. Some lenders will do up to age 85, and a handful of others past 100.
Buy to let investments set up to draw income
Buy-to-let landlords are another group who favour interest only mortgages over a repayment mortgage. If you fit into this category you’re better placed to maximise the income from your rentals by keeping your mortgage payments low whilst placing confidence in the growth of your property portfolio to ensure the initial capital can be repaid at the end of the term.
Choosing the repayment method that’s right for you and your particular circumstances needs to be a considered choice. It’s important you speak to an expert to assist you further with this decision.
Interest only repayment vehicles
Whilst it’s been stated already that one of the main advantages of interest only versus repayment are the lower monthly payments, this can be quite deceptive. Regardless of the savings you may be making the fact remains you still need some form of repayment vehicle to pay back the capital owed at the end of the term.
If you don’t have any repayment vehicle in place all you’re doing is treading water with the prospect of a large debt due on your property and no way to repay it. For this reason, almost every lender now will not lend on a “pure interest only” basis and require a suitable repayment vehicle to be in place, to ensure borrowers can pay the loan back at the end of the term.
So, what investment(s) can you use to repay your loan? Well, there’s quite a few options available to you.
Using sale of your main residence (the mortgaged property)
One of the most common vehicles used these days is the most obvious – your property. Be careful with this option, though, as it carries some quite obvious risks. Whilst property prices in the UK haven’t had a serious price correction for quite some time it’s still a fact that values can go down as well as up. This option needs careful thought; especially if it’s a property you live in rather than for commercial reasons.
Most lenders don’t allow this type of repayment vehicle, however there are some specialists happy to accept if there is at least a minimum amount of equity in the property, some say at least £150,000, and a small number happy with just £100,000 – essentially the amount that could be used to buy a retirement property.
Other repayment vehicles that will be considered by lenders would be:
Endowment policies to repay a mortgage (less common these days)
Tax-free lump sum from a pension plan to repay a mortgage (25% of pension pot)
ISAs to repay a mortgage
Stocks and shares to repay a mortgage
Unit Trusts to repay a mortgage
Open Ended Investment Company (OEICs) to repay a mortgage
Investment Bond to repay a mortgage
Government Securities to repay a mortgage
Family inheritance or trust fund to repay a mortgage
A number, if not all, of these vehicles would be heavily scrutinised by a lender before the mortgage can be approved. Make an enquiry so one of the specialists can contact you and guide you through this process.
Are interest only mortgages a good idea?
The short answer is ‘yes’. An interest only mortgage can be the best solution for your property purchase, depending on your needs and circumstances.
The main reason interest only mortgages receive such close scrutiny by the financial media has nothing to do with the actual repayment method itself. It has everything to do with how the repayment vehicles set up to cover the capital element have been sold over the years.
Traditionally interest only mortgages were accompanied with an endowment savings policy designed to achieve an investment objective at (or before) maturity, equivalent to the capital owed to the lender. The reality, for a number of property owners, has been very different with large shortfalls due to over zealous charging structures and under-performing investments.
It is estimated that 600,000 interest only mortgages will be at the end of their term in 2020. In some cases where there are no other plans in place to cover any shortfall, homeowners may face no choice other than to sell their property in order to settle their debt.
These problems with interest only mortgages have been well documented. It is always prudent to ask an expert for advice before proceeding with your plan.
Can I switch from interest only to a repayment mortgage?
The key with any repayment vehicle used for an interest only mortgage is regular monitoring of the underlying investments. Once it becomes clear that these investments are not going to achieve their objective you must take action. Don’t make the mistake of ignoring it or hoping it will all be okay. It’s best to make changes sooner rather than later.
The good news is there are a number of options available to you should you wish to make changes to your interest only mortgage. You may wish to make additional payments towards your repayment vehicle, or make overpayments to the mortgage, in order to get it back on track. Most investment vehicles are flexible and will accept additional monthly payments and/or one-off lump sums.
Another option is switching away from an interest only mortgage and porting to a repayment mortgage. This way you know your capital is slowly reducing throughout the term with a guarantee of completion at the end. You can also take out a repayment mortgage to run alongside your interest only mortgage to cover the projected shortfall of the repayment vehicle, essentially splitting the mortgage to part interest only part repayment.
If you’re approaching retirement and worried that it may be too late to switch from your interest only mortgage to a repayment mortgage don’t despair. Whilst it’s true most lenders usually have a maximum age at the end of the term of 65, some go as high as 75, a few go up to 85, and one or two specialists will lend past 100.
Switching mortgage repayment method can be tricky. If you get in touch, we can make sure an expert will be able to provide you with the right advice in this area.
How to get an interest only mortgage with bad credit
Whether looking for a interest only or repayment mortgage, bad credit doesn’t have to be a millstone around someone’s neck. Adverse credit information can be retained on your credit file for six years; however, this doesn’t mean you have to wait until this information is no longer showing to make a mortgage application.
The first thing you should do is ascertain an up to date credit check so you know what is showing. A poor credit record can cause problems with certain lenders depending on the type of issue you’ve had and when it was registered.
Despite this, there are some lenders who will look at applications from borrowers who have had credit issues in the past and a few who specialise in these types of applications.
Thankfully there are specialist lenders happy to consider:
Interest only mortgages with Late payments
Interest only mortgages with Defaults
Interest only mortgages with CCJs
Interest only mortgages with Mortgage arrears
Interest only mortgages with Debt management plans
Interest only mortgages with IVAs
Interest only mortgages with Bankruptcy
Interest only mortgages with Repossession
Whatever your situation, don’t lose hope. There’s lots of specialised advice available to help you complete your property purchase.
Still unsure? Talk to someone who can explain the pros and cons for repayment vs interest only mortgages today and help you make an informed decision.
If you like anything in this article or you’d like to know more, call Online Mortgage Advisor today on 0800 304 7880 or make an enquiry here.
Then sit back and let us do all the hard work in finding the broker with the right expertise for your circumstances. – We don’t charge a fee and there’s absolutely no obligation or marks on your credit rating.
*Based on our research, the content contained in this article is accurate as of most recent time of writing. Lender criteria and policies change regularly so speak to one of the advisors we work with to confirm the most accurate up to date information. The info on the site is not tailored advice to each individual reader, and as such does not constitute financial advice. All advisors working with us are fully qualified to provide mortgage advice and work only for firms who are authorised and regulated by the Financial Conduct Authority. They will offer any advice specific to you and your needs. Some types of buy to let mortgages are not regulated by the FCA.Think carefully before securing other debts against your home. As a mortgage is secured against your home, it may be repossessed if you do not keep up with repayments on your mortgage. Equity released from your home will also be secured against it.
Pete, an expert in all things mortgages, cut his teeth right in the middle of the credit crunch. With plenty of people needing help and few mortgage providers lending, Pete found great success in going the extra mile to find mortgages for people whom many others considered lost causes.
The experience he gained, coupled with his love of helping people reach their goals, led him to establish Online Mortgage Advisor, with one clear vision – to help as many customers as possible get the right advice, regardless of need or background.
Pete's presence in the industry as the 'go-to' for specialist finance continues to grow, and he is regularly cited in and writes for both local and national press, as well as trade publications, with a regular column in Mortgage Introducer and being the exclusive mortgage expert for LOVEMoney. Pete also writes for OMA of course!
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