Interest-only vs repayment mortgages Interest-only mortgages explained
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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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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