What is a mortgage? Interest-only mortgages and repayment mortgages
There are two main types of mortgage: repayment mortgages and interest-only mortgages. In this guide we explain how each type works and the key differences between them.
The vast majority of mortgages currently offered by lenders are repayment mortgages. However, if you're taking out a buy-to-let mortgage or have a large income, you're more likely to take out an interest-only mortgage.
- If you'd like some impartial advice on the best mortgage for your personal circumstances, you can call Which? Mortgage Advisers on 0808 252 7987.
What is a repayment mortgage?
With a repayment mortgage - or capital repayment mortgage, to give it its full name - you gradually repay the money you borrowed over your mortgage term (the period your mortgage has been set up to last for - often 25 years).
You make one payment each month to your lender. Part of it goes towards the interest charged by your lender and part goes towards repaying the money you've borrowed.
In the first few years of your mortgage period, most of your mortgage payments go towards repaying the interest, with a small part allocated against the capital. Over time, the balance switches, so you're paying off an increasing amount of the capital each month.
With a repayment mortgage, you are guaranteed to repay the full loan by the end of your mortgage term, provided you make your repayments in full each month.
This can make it easier to get a cheaper mortgage deal in the future, as the bigger the amount of equity you own in your home (ie the share that you've paid off and own outright), the better mortgage deals you'll be able to get.
- Want to understand more about repayment mortgages? Which? Mortgage Advisers offers tailored mortgage advice to help you find the best deal for you. You can call for a free consultation on 0808 252 7987
What is an interest-only mortgage?
With an interest-only mortgage, you only pay interest to your lender each month. You don't pay off any of the capital that you've borrowed until the end of the mortgage term.
This means that you need to make other arrangements for paying back the capital. Mortgage lenders describe this as setting up a separate 'repayment vehicle', which usually means paying a separate monthly amount into an investment, such as a stocks and shares Isa.
Taking out an interest-only mortgage is risky as there is no guarantee that the investment will be worth enough to pay off the mortgage in full at the end of the term. If the gamble doesn't pay off, you will face a shortfall when you come to repay your mortgage.
You also end up paying more interest overall on an interest-only mortgage as you are paying interest on the entire sum borrowed for the whole term (unlike with a repayment mortgage, where you'll be gradually paying it off and interest is only charged on the amount still owed each month).
Interest-only vs repayment mortgages
You can compare interest-only mortgages and capital repayment mortgages side by side in our table:
|Interest-only vs repayment mortgages|
|Interest-only mortgage||Repayment mortgage|
|How much will I pay each month?||Just the interest charged by your lender||The interest charged by your lender plus part of the mortgage loan itself|
|How much will I owe at the end of the mortgage term?||The full amount originally loaned to you by your mortgage provider||Nothing|
|What is the monthly interest based on?||The full amount originally loaned to you by your mortgage provider||The amount you still owe on your mortgage loan, which will decrease each month|
|What are the risks?||You will need to pay back the entire mortgage loan at the end of the term, so the biggest risk is not having enough money available at that point, for example if your investment hasn't increased in value to the level you thought it would. If you don't meet every monthly repayment in full, your home may be repossessed. Talk to your lender if you're worried about this||If you don't meet every monthly repayment in full, your home may be repossessed. Talk to your lender if you're worried about this|
|What else do I need to know?||You are free to invest the money you would have spent on monthly capital repayments elsewhere until the end of the term, meaning you could potentially make a profit. However, as you'll be paying interest on the entire price of the house for the duration of the mortgage, you'll pay more interest in the long run than you would with a repayment mortgage||Generally speaking, the greater your equity (the portion of the property that you own outright), the better mortgage rates you'll have access to. As your equity will be growing with each monthly payment, you'll be in a stronger position when the time comes to change mortgage|
Interest-only mortgage shortfalls
If you're getting near the end of your mortgage term and think you may have problems repaying the capital, you should speak to your mortgage lender as soon as possible and ask whether you can switch to a repayment mortgage. Doing this will increase the cost of your monthly payments, but you'll have the security of knowing that you are repaying the loan. If your budget is tight you may be able to switch to a part-repayment/part-interest-only mortgage to start with.
You could also ask whether you can extend the mortgage term to give you more time to put alternative funding in place. Alternatively, your mortgage provider may allow you to make overpayments to clear the loan. Check whether fees will be charged for doing any of the above.
- It's worth talking to an independent mortgage adviser if you want impartial advice. You can call Which? Mortgage Advisers on 0808 252 7987 for a free, confidential chat
Other interest-only mortgage options
If you can't come to an arrangement with your lender, you'll need to find another way of repaying the capital. Options include:
- Using savings or investments to cover some or all of the shortfall. Depending on the amount of money you need and how long you have remaining on your mortgage term, one option is to set up a new investment fund - such as a stocks and shares Isa - to cover the loan. We'd recommend taking independent financial advice, as there are no guarantees your savings or investments will grow enough in value to cover the final repayment.
- Older borrowers could consider taking a tax-free lump sum from their pension to repay the mortgage debt. When you retire you can take up to 25% of your pension pot as a tax-free lump sum, but this will mean a smaller retirement income.
- You could also sell your property to repay the loan but this will probably be a last resort for many. You may not achieve the selling price you would like and, if you're living there, you may struggle to find alternative accommodation that you're happy with and able to afford.
Your home may be repossessed if you do not keep up repayments on your mortgage.
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