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By Pete Mugleston | Mortgage Advisor

Pete has been a mortgage advisor for over 10 years, and is regularly cited in both trade and national press.

Updated: 7th September 2020*

When you purchase a property, it’s important to have a viable plan to pay for it. A mortgage lets you borrow the money from a mortgage lender. You repay the debt, with interest, over an agreed period of time, or on a set date in the future.

There are two methods available for repaying a mortgage – capital repayment and interest-only. The decision you need to make is which method is right for you, and your circumstances.

In this article we look at:

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What’s the difference between interest-only and a repayment mortgage?

An interest-only mortgage means your monthly mortgage payments only cover the interest owed on the full amount of capital borrowed, you repay the full loan amount at the end of the term. With a repayment mortgage each monthly payment covers some interest and some capital, by the end of the mortgage you have repaid your mortgage in full.

If you have an interest-only mortgage you will need a way to pay off the capital loan at the end of the mortgage term, usually an appropriate repayment vehicle. The repayment vehicle you choose is up to you, however, you need to be confident that you will have enough to repay the capital debt in full by the end of the term. Most mortgage lenders will insist on having a clear understanding as to how you intend to repay the debt before agreeing to an interest-only mortgage.

Capital repayment mortgage

A repayment mortgage is regarded as the most conventional method for repaying a mortgage debt. While an interest-only mortgage separates capital and interest, a capital repayment mortgage does the opposite.

With a repayment mortgage you will make a monthly payment that consists of both capital and interest, therefore, the capital you borrow gradually reduces throughout the term. By the end, providing all payments have been met, the capital debt will have been totally repaid and the mortgage 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.

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 one of the experts we work with will get in touch to give you some more details.

The benefits of a repayment mortgage

Peace of mind

If you’re looking for complete assurance and a guarantee that your mortgage debt 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, as agreed in your mortgage agreement. It’s as simple as that.

Ability to keep payments low

There’s a great deal of flexibility when it comes to repayment mortgages. If you’re a first-time buyer 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 mortgage agreements.

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. The payments you make each month 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.

TermInterest-OnlyTARRepaymentTAR
20 years£500£319,938£1,109£266,169
25 years£500£349,922£948£284,478
30 years£500£379,906£843£303,495

(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 amount of capital debt 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.

Downsizing

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, home and the remainder will pay off the outstanding mortgage debt.

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 mortgage lenders will go 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.

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.

Without a 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 has strict eligibility requirements you will need to meet, and almost all providers will require a suitable repayment vehicle to be in place, to ensure borrowers can pay the loan back at the end of the mortgage agreement.

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 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.

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 may be happy with just £100,000 – essentially the amount that could be used to buy a retirement property.

Other vehicles you could use to repay mortgage debt lenders will consider:

  • Endowment policies (less common these days)
  • Tax-free lump sum from a pension plan (25% of pension pot)
  • ISAs
  • Stocks and shares
  • Unit Trusts
  • Open Ended Investment Company (OEICs)
  • Investment Bond
  • Government Securities
  • Family inheritance or trust fund

A number, if not all, of these vehicles would be heavily scrutinised by a lender before the mortgage application can be approved. 

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 mortgage were accompanied with an endowment savings policy designed to achieve an investment objective at
(or before) maturity, equivalent to the capital debt 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.

An estimated 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.

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 that 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.

How to get an interest-only mortgage with bad credit

Whether looking for an interest-only or repayment mortgage, bad credit doesn’t have to be a millstone around your 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 interest-only mortgage lenders happy to consider:

  • Late payments
  • Defaults
  • CCJs
  • Mortgage arrears
  • Debt management plans
  • IVAs
  • Bankruptcy
  • Repossession

Whatever your situation, don’t lose hope. There’s lots of specialised advice available to help you complete your property purchase. The expert mortgage brokers we work with have experience of helping people with all kinds of bad credit histories, get in touch for a free, no obligation chat and we’ll connect you with a broker who can help.

Speak to an expert

Talk to someone who can explain the pros and cons for repayment vs interest-only mortgages today and help you make an informed decision, based on your own set of circumstances.

Call 0808 189 2301 or make an make an online enquiry for a free, no-obligation chat.

We’ll match you with one of the expert whole-of-market brokers who will be happy to answer your questions and find the right mortgage solution for the best available price for you.

Updated: 7th September 2020
OnlineMortgageAdvisor 2020 ©

FCA disclaimer

*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.