Interest Only Mortgages

What is the difference between an interest-only mortgage and a repayment mortgage?

An interest-only mortgage is a home loan where your monthly mortgage payments only cover the interest you are being charged on the total amount you have borrowed (the capital); this differs from a repayment mortgage, in which your monthly mortgage payments are calculated to cover both the loan interest, and repayment of the amount borrowed over the agreed repayment term. Repayment mortgages are sometimes referred to as “capital and interest” mortgages, to differentiate them from interest-only mortgages.

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With an interest-only mortgage, as you are not repaying any of the mortgage debt itself, the monthly interest-only repayments can be significantly lower than they would be for a repayment mortgage of the same amount. However, you will need to have a plan – sometimes referred to as a “repayment vehicle” – in place to repay the total balance of the mortgage on or before the end of your repayment term.

Examples of repayment vehicles can include endowment policies, pensions, ISAs or the sale of the property itself. Lenders who offer interest-only mortgage products will each have their own policies on what types of plans and investments they are willing to accept as repayment vehicles. Cash in a savings account, for example, may not be acceptable to some lenders as a repayment vehicle for an interest-only mortgage.

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What are the differences in payments between an interest-only and a repayment mortgage?

Interest-only mortgages have the benefit of lower monthly payments than on a repayment mortgage of the same amount; that is because the payment only covers the interest, and does not repay any of the mortgage capital over the term. However, because the balance is not reducing, the total interest charged over the life of the mortgage is more than on an equivalent repayment mortgage.

There can be hundreds of different mortgage deals on the market at any given time, but here we will look at representative interest rates of 3%, 4% and 5% to illustrate how an interest-only mortgage and a repayment mortgage would compare. Our examples are based on a purchase price of £232,000 with a 25% deposit put down and mortgage borrowing of £174,000, taken out for a 25-year term.

 

Interest Rate

Interest-Only Mortgage

Repayment Mortgage

3%

At an interest rate of 3%, the interest-only mortgage payment would be £435.
The total amount repayable over the term would be £304,500, which includes:the £174,000 borrowed, which needs to be repaid at the end of the term, and;total interest of £130,500, paid in equal monthly payments over 25 years.

At an interest rate of 3%, the repayment mortgage payment would be £825.
The total amount repayable over the term would be £247,538, which includes:the £174,000 borrowed, which is repaid by the monthly payments over 25 years;total interest of £73,538, paid as part of the monthly payments over 25 years

4%

At an interest rate of 4%, the interest-only mortgage payment would be £580.
The total amount repayable over the term would be £348,000, which includes:the £174,000 borrowed, which needs to be repaid at the end of the term, and;total interest of £174,000, paid in equal monthly payments over 25 years.

At an interest rate of 4%, the repayment mortgage payment would be £918.
The total amount repayable over the term would be £275,531, which includes:the £174,000 borrowed, which is repaid by the monthly payments over 25 years;total interest of £101,531, paid as part of the monthly payments over 25 years.

5%

At an interest rate of 5%, the interest-only mortgage payment would be £725.
The total amount repayable over the term would be £391,500, which includes:the £174,000 borrowed, which needs to be repaid at the end of the term, and;total interest of £217,500, paid in equal monthly payments over 25 years.

At an interest rate of 5%, the repayment mortgage payment would be £1,017.
The total amount repayable over the term would be £305,156, which includes:the £174,000 borrowed, which is repaid by the monthly payments over 25 years;total interest of £131,156, paid as part of the monthly payments over 25 years.

 

The calculations assume a constant interest rate, and do not include any other factors such as home insurance, redundancy insurance or payments towards a repayment vehicle.

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What is a part-and-part mortgage?

As the name perhaps suggests, a “part-and-part” mortgage is part repayment and part interest-only. With this type of mortgage, you would have a repayment vehicle that only covers part of the total mortgage debt. For example, let us say you take out a £100,000 mortgage, but only have a repayment vehicle covering £75,000. In this case, £75,000 of the mortgage would be on an interest-only basis, and the remaining £25,000 would be on a repayment basis.

Your monthly mortgage payment would be calculated to cover the interest accruing on the entire mortgage capital, plus a proportion to repay the £25,000 repayment portion over the agreed repayment term. At the end of the mortgage term, your mortgage balance will have been reduced from £100,000 to £75,000, which will then be paid off by the appropriate repayment vehicle.

Part-and-part mortgages offer a middle ground between a full repayment mortgage and a full interest-only mortgage. The monthly payments are lower than on an equivalent repayment mortgage, and because part of the mortgage balance is being repaid over the term, you pay less total interest than you would on an interest-only mortgage.

Who might be suited to an interest-only mortgage?

Interest-only as a mortgage repayment method can be suitable for all types of borrowers, from first-time buyers and home movers, to buy-to-let investors and those looking to remortgage. An interest-only mortgage is not right for everyone – and some lenders do not offer interest-only mortgages at all – however, this type of mortgage can be advantageous for many reasons when individual borrowing needs and personal circumstances are taken into consideration.

In areas where house prices are high, such as in London and the South-East, buying a property with an interest-only mortgage can be seen by some as a cheaper option than renting a property. There is also the view of certain home buyers that, while you may not be paying off the actual capital of the loan, you are on the property ladder and you do own your own home.

Many buy-to-let investors use interest-only mortgages because it enables them to keep their monthly mortgage commitment to a minimum – thereby maximising their monthly rental yield – whilst opting to make lump-sum part repayments towards the mortgage capital at periods throughout the loan if required. An interest-only mortgage can also reduce the monthly cost of property ownership if the investor is looking primarily for capital growth rather than longer-term income.

The benefits of interest-only mortgages can also apply to the self-employed, contractors, freelancers, and others who may have irregular monthly income. In this case, the lower monthly interest-only repayments can help when budgeting.

Interest-only mortgage advice

With our team of experienced brokers who specialise in interest-only mortgage lending, we can access the whole of the UK mortgage market to help you find the right deal. In many cases, our ongoing working relationships with specialist lenders means we may be able to access better interest-only mortgage rates than if you approached lenders yourself. For more information, please contact our team to discuss the benefits of interest-only mortgages and how we can help you secure the mortgage that is right for you.