Interest only vs repayment
How to repay your mortgage
There are two ways to repay the amount you have borrowed (the ‘capital’). Their advantages and disadvantages are described below.
Repayment Mortgage (also called a 'capital and interest' loan)
Your monthly payments gradually pay off the amount you owe as well as paying the interest charged on the loan. Provided you make all the agreed payments, the loan will be fully paid off by the end of the mortgage term.
Source: Financial Services Authority website May 05
Interest-only mortgage
Your monthly payments cover only the interest on the loan. They do not pay off any of the capital. You will need to arrange to pay into a separate savings or investment scheme/plan to build up a lump sum to repay the capital at the end of the mortgage term. It is your responsibility to make sure you have enough money to repay the mortgage at the end of the term - otherwise you could lose your home.
Source: Financial Services Authority website May 05
Advantages and disadvantages of the repayment methods
| Repayment Mortgage | Interest-only mortgage | |
|---|---|---|
| Will it pay off the mortgage? | Yes, as long as you make all the payments agreed with the lender, the whole loan will be repaid by the end of the mortgage term. | No, not on its own. You need to have some other arrangement for repaying the loan. You will need to make regular payments to a savings or investment plan to build up a lump sum. NB: There is a risk that the plan will not grow enough to pay off the mortgage in full. |
| What if interest rates go up? | It doesn't matter which method you have, if interest rates rise, your payments will normally increase. | |
| Moving home and re- mortgaging Whether you move home and stay with the same lender or take a mortgage with a new lender, you will need to repay the mortgage and start a new one. | You will usually have paid off some of the ‘capital’ and so will need to pay back less than you borrowed. When arranging your new mortgage, even if you are borrowing more, see if you can afford the new monthly payments over the term that you had left on the last mortgage – you don't have to take a repayment mortgage over 25 years. | As you won't have repaid any ‘capital’ you will need to pay off the same amount that you borrowed, but you can carry over any accompanying savings plan to your new mortgage and the mortgage term for this part of the loan will be what's left of the term of the plan. If the new mortgage is bigger than the old one, you need to decide how you will pay off the extra loan (this could be done on a repayment or interest-only basis). |
| What if you run into problems keeping up your monthly repayments? | You could ask your lender to extend the term or accept interest-only payments for a while. This reduces the amount you pay each month in the short term but increases the total cost of the loan. Your lender might agree to stop your payments for a while. | Your lender might agree to reduce or even stop the mortgage payments for a while. However, you will not necessarily be able to reduce the amount you pay each month into a savings scheme, particularly if it is an endowment policy. |
| Is this a suitable mortgage for you? | Yes, if you want to be absolutely sure that your loan will be fully repaid at the end of the term. Don’t forget your monthly payments could increase if interest rates rise. | Whether an interest-only mortgage suits you depends on whether you’re comfortable with taking the risk of fully repaying your mortgage with a savings plan which is linked to the stockmarket. If you are not comfortable with this risk, a repayment mortgage is likely to be a better choice. |
