Interest Only Vs Repayment Mortgages

Weighing up the pros and cons

With an interest-only mortgage, you repay the interest on your mortgage every month and pay off the capital debt - the value of the property - at the end of the mortgage. As you only pay off the interest, the repayments on an interest-only mortgage are cheaper than those on a repayment mortgage, where you pay off a combination of interest and capital debt each month.

But how do you negotiate the capital debt at the end of the mortgage term? Unless you intend on selling your house to repay the capital debt - which is risky, as house prices are never guaranteed to rise - it's a good idea to put money aside each month, typically in some kind of investment vehicle, such as an individual savings account (ISA). This way, at the end of your mortgage term, if the value of your investment is greater than the outstanding debt, you could be left with some profit from your savings, as well as a lump sum to clear your debt.

In recent years, increasing numbers of first-time buyers have taken out interest only mortgages, and have just paid the interest - not paying any money into an investment. With high house prices, this is the only way some people have managed to afford to buy property. When taking out an interest only mortgage and just paying the interest, they are relying on their property going up in value, being able to sell it a few years down the line for a profit, and then buying a property with a repayment mortgage.

There are a number of risks here. Firstly, house prices are not guaranteed to go up, and could even fall. Secondly, many people sort out their mortgage and then forget about it. If you never get around to converting your Interest only mortgage to a repayment mortgage, and you have no investment fund building up, there is a very real risk that you may get to the end of your 25 year mortgage term still owing all of the capital initially borrowed and with no way of repaying it.

With repayment type mortgages, the monthly repayment you make to the lender each month consists of the interest you owe plus a little bit of the capital you owe. If you keep up all the repayments on your repayment type mortgage, you are guaranteed to have paid off the mortgage at the end of the term. Repayment type mortgages are therefore the safest option, and are by far the most popular mortgage type in the UK.

Buy-to-let investors are the only borrowers who are advised to take out interest-only mortgages with no investment vehicle. That is because the rent covers your interest payments, and the long term plan is generally to sell the property in the future, and pay off the capital at that point.