Interest-only vs repayment mortgages Interest-only mortgages explained

A house and a percentage sign on a see-saw

Interest-only mortgage repayments can be lower, but you'll need to save elsewhere too

If you're looking for a mortgage, there are two main options: a repayment mortgage or an interest-only mortgage. 

During the term of an interest-only mortgage, your payments to your lender only go towards repaying the interest charged - you don't actually repay any of the money you originally borrowed (the capital).

This means you should also make other arrangements for paying back the capital. For example, you could pay a separate monthly amount into an investment such as a stocks and shares Isa.

In our video, you can learn more about the differences between interest-only and repayment mortgages. Below the video we explain the potential disadvantages of interest-only mortgages and why it could be advisable to take out life insurance if you opt for this type of mortgage.

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Video: what is a mortgage?


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Video transcript

Unless you have a stack of cash sitting around, getting a mortgage is the essential part of buying a home. But how is a mortgage different from a loan and what type should you get? Unlike a normal loan, a mortgage is specifically tied to the house you're buying. You usually borrow a percentage of the value of that property repaying the amount you've borrowed plus interest charged by the mortgage lender.

If you fail to repay your mortgage, your house could be taken away and sold to cover the loan you've taken out. When you are buying a house, for yourself, there are two main types, of mortgage to chose from. With a repayment mortgage, you gradually repay the amount he borrowed, this is known as the capital.

Each month, some of what you pay goes towards paying off the capital, while the rest covers the interest. By the end of the mortgage, usually in 25 years, you would have repaid everything you've borrowed. An interest only mortgage usually has lower monthly payments because you're not paying off the actual money you borrowed, just the interest.

It's up to you to pay off the capital at the end of the term. By paying a separate amount in to an investment for example. New mortgages usually charge you a lower rate of interest in the first few years to entice you in. This can be fixed or variable. A fixed rate is usually slightly higher, but gives you the security of a regular payment each month.

On a variable rate mortgage, the monthly repayment can change. If the interest rate goes down, you could pay less, but there's a chance it can go up, leaving you to pay more each month. Whatever type you decide you can use the which mortgage comparison tables to search through hundreds of deals from different providers to choose the best deal for you.

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Interest-only mortgages: disadvantages

While the monthly repayments you make on an interest-only mortgage are likely to be lower than with a repayment mortgage, there are disadvantages:

  • Many mortgage providers won't lend on an interest-only basis. If house prices drop, as they have in recent years, there's a risk that borrowers will be trapped in negative equity, which poses a risk for lenders. As a result many won't lend at all.
  • If lenders will give you a mortgage on an interest-only basis you may need a much bigger deposit than you would with a repayment mortgage.
  • If you don't build up a separate fund to repay the mortgage, you may struggle to switch mortgages if your interest rate goes up.
  • You will pay more interest overall on an interest-only mortgage as you are paying interest on the whole loan for the whole term.
  • There is no guarantee that your separate investment (for example, your stocks and shares Isa) will grow fast enough to pay off the mortgage in full at the end of the term.

Life insurance to cover your mortgage repayments

If you have a family or other dependents and want to make sure your mortgage is paid off if you die, it's worth considering a life insurance policy.

Under an interest-only mortgage, the outstanding capital on your mortgage stays the same throughout the mortgage term. It's therefore often worth taking out a life insurance policy under which the sum insured stays the same too. So if you're expecting to pay off your mortgage over 25 years, you could take out a 25-year life insurance policy. A policy that keeps the same cover for a fixed period is called a 'level-term policy'.

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