Guide to interest-only mortgages vs repayment mortgages
Interest-only mortgages were once the norm in the UK. They have become far harder to get hold of in recent years, as lenders and regulators consider them more risky than capital-and-interest (also known as ‘repayment’) mortgages. Some lenders have withdrawn from offering interest-only arrangements except for buy-to-let mortgages (see below), while others will provide them but will ask for a large deposit or equity, often 50% or more.
How they work
With an interest-only mortgage, the payment you make to the mortgage lender each month comprises just the interest you owe them for that month. So you are not paying off any of the capital you owe.
When you take out an interest-only mortgage, you are supposed to also make a monthly payment into an Individual Savings Account, endowment or other investment. The hope is that the investment will then generate sufficient returns to pay off the capital sum you still owe at the end of the mortgage term.
However, there is no guarantee of this, so any interest-only mortgage carries an element of risk.
In the boom years of the property market, increasing numbers of first-time buyers took out interest-only mortgages, and have just paid the interest, not paying any money into an investment. With high house prices, this was the only way some people have managed to afford to buy property.
When taking out an interest-only mortgage and just paying the interest, borrowers relied 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.
But this approach was fraught with risk. Firstly, house prices are not guaranteed to go up. 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-type, 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.
To avoid this happening going forward, most mortgage lenders now make it very difficult for borrowers to take out interest-only mortgages. They may demand a very big deposit (up to 50%) and/or ask for tangible proof that you have an investment plan in place to pay off the mortgage at the end of the term. And some have stopped accepting plans such as a future inheritance as backing for taking out an interest-only mortgage.
With a repayment-type mortgage, 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 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.