When most people imagine a mortgage, they think of making monthly payments against a large borrowed sum, plus interest, for a term of 25 or even 35 years, and then owning the home outright at the end of that term—with no more mortgage bills and with the home as an asset for you and your posterity (or maybe, unfortunately, your long-term care). But there are actually two ways to repay a mortgage: repayment, as described above; or interest-only. When it comes to comparing mortgages, it pays to know the difference.
Repayment vs. interest-only mortgage
With a repayment mortgage, you pay off portion of the original loan, plus interest, each month and own the property at the end.
With an interest-only mortgage, you… do what is says on the tin and only pay off the interest on the loan. This can mean significantly lower monthly payments. If you take out a £200,000 mortgage for 25 years at an interest rate of 3%, you’ll pay £944.22 a month with a repayment mortgage, but just £500 a month on an interest-only mortgage.
However, at the end of the term of an interest-only mortgage, you then owe the lender the full principal, in a lump sum. Ideally, you would have been socking away money each month to pay this amount, or investing it with the aim of ending up with enough at the end of the mortgage term. If not, you’ll need to sell the property to pay off the outstanding balance on the loan.
Additionally, you’ll ultimately pay more overall for an interest-only mortgage because you won’t be reducing the balance each month, so the interest you pay won’t fall.
With that same 25-year £200,000 mortgage with a 3% interest rate, you’ll ultimately end up paying £ 284,526.79—including £84,526.79 of interest payments—with a repayment plan. However, with an interest-only mortgage, you’ll end up paying £350,000, including £150,000 in interest, and £200,000 owed in a lump sum at the end.
But those figures don’t account for the possibility of remortgaging, with a lower interest rate, as your balance falls with a repayment mortgage, possibly saving you even more.
However, you may still be intrigued by the low monthly payments on interest-only mortgages and convinced you can invest the difference and do better in the stock market. You may want more control over your money and where it goes each month. But before you take the plunge into interest-only mortgages, you might want to hear about their checkered past.
A brief history of interest-only mortgages
In the heady days before the 2008 financial crash, interest-only mortgages were en vogue, with borrowers—and lenders—gambling that they could accumulate enough money by the end of the term to pay off the loan. But it quickly became apparently that lenders had negligent issued many people with interest-only mortgages without any proof they could pay them off. In fact, lenders were using the low monthly payments of interest-only mortgages to get people into homes they otherwise couldn’t afford. These bad mortgages, in the US and here, contributed significantly to the 2008 financial crash and subsequent recession.
Interest-only mortgages today
In the aftermath of the recession, banks tightened up lending criteria for mortgages and interest-only mortgage deals became harder to obtain. Today they’re mostly confined to the buy to let sector, where landlords often sell the property at the end of the mortgage term (hopefully for a profit, if property prices have risen) and exit the rental game.
Now, to obtain an interest-only as an owner-occupier, you’ll have to show an approved repayment plan. Previously, lenders accepted the possibility of a future cash influx, like an inheritance, but that no longer cuts the mustard. Today, different lenders accept different repayment strategies but stock market investments and Isas are common. You may want to consult with a financial planner.
Your lender may also make periodic checks to see if your repayment plan is bearing the required fruit.
Is it a good idea?
In general, interest-only mortgages aren’t a good option for most borrowers. With an interest-only mortgage, you’ll pay more overall, be hit with huge bill at the end of the mortgage term, and may be forced to sell the property at that point. Throughout the term of the mortgage, you’ll also have to both keep track of an investment plan for the mortgage principal and your monthly payments on the mortgage interest.
Repayment mortgages are a better deal because you’ll pay less overall, you may be able to remortgage with a lower interest rate as your balance decreases, and you own the home outright at the end. They’re also more straightforward and easier to look after.
However, interest-only plans are sensible, and in fact, the standard option, for buy to let borrowers, particularly if you want a built-in exit from renting property, perhaps timed with your retirement.