Interest Only v Repayment Mortgages

Interest Only vs Repayment Mortgages:

This section will give you an introduction to mortgage repayment types and how they work.

It includes an explanation of what mortgages are and the different ways in which they can be established and repaid, depending on your own views, needs and circumstances.

1.  Loans Secured on Property - Mortgagee and Mortgagor

A mortgage is the term for using property as security for money borrowed.  You still own the house but you have allowed a legal restriction or interest to be placed on it.

The person borrowing the money is known as the 'mortgagor' ('debtor' in Scotland) and the person lending the money is known as the 'mortgagee' ('creditor' in Scotland).

For the majority of people, purchasing a home is the largest expense they will ever undertake and not many of us could afford to buy it outright with cash.

Demand for mortgages

House prices have risen dramatically over the past few years and the need for mortgages has therefore increased.  There has also been a vast expansion in the number of mortgage lenders and the types of products they offer.  This gives you, as a borrower, choice and competitive products.

If you want to purchase a home by using a mortgage, mortgage lending companies may ask you to find a certain amount of the property purchase price yourself, such as 5% or 10%.  This is known as a deposit and they will lend you the rest of the purchase price over a number of years.

Once you have your mortgage arranged you can buy your property with the money.  You will make payments to your mortgage lender on a regular basis and the amount they lent you will be secured on the property you buy.

Mortgages are loans secured on property.  The loan is secured on the property you buy because the amount borrowed is usually substantial.  This means that the mortgage lender is taking a considerable risk that you will pay back the money you borrowed. 

If you do not make your required mortgage payments, because the mortgage is secured on the property, the lender has the right to take possession of it from you and sell it in order to try and recover the amount you borrowed.

2.  Interest Only Basis

When you make a payment to the mortgage lender under this type of mortgage your repayments are only made up of the interest due on the lump sum you borrowed.  You pay back the interest throughout the term of the mortgage and at the end of the term you have to pay back the capital you borrowed as a lump sum.

To do this, most people need a long term savings or investment plan. 

The most common types of vehicles used in connection with mortgages have been endowment plans, pensions, Individual Savings Accounts and Personal Equity Plans.  Each of these can be set up with the idea of long term growth and can actually be targeted on the amount you need to have at the end of the mortgage term.

By looking at the amount you need at the end of the mortgage term regular premiums can be worked out for you, based on assumed rates of growth, after any charges have been made on the policy.  If the assumed rate of growth is achieved over the mortgage period then you will have the lump sum you need. 

However, if the growth rate is not achieved the lump sum will be less.  Likewise, if the growth rate is exceeded, the lump sum will be more than you need.

The lump sum used to repay your mortgage will usually be free of tax.

Interest only mortgages are higher risk, please read the section on endowment mortgages.

3.  Capital and Interest Repayment

Each time you make a payment to your mortgage lender you will be repaying some of the capital you borrowed and some of the interest due on that capital.

With this type of mortgage, as long as you have made the correct repayments throughout the whole term of the mortgage, the balance outstanding at the end of the term will be zero.

If you choose this type of repayment method, you should also consider at least some basic form of life insurance.  Many people do not take out any insurance and are unaware of the consequences of dying with a mortgage outstanding.

Protecting the mortgage borrowers with insurance can generally be done easily and cheaply and there are various types of decreasing life insurance to choose from.

4.  Making Mortgage Payments

Once you have agreed the amount of money to borrow to purchase your home, you will need to decide how the money will be repaid over the years.

There are two ways in which this can happen:

• You can repay your mortgage on an interest only basis
• You can repay your mortgage on a capital and interest repayment basis

5.  Interest Only versus Repayment

They are very different ways of repaying a mortgage and you should think carefully about which one to choose. 

Your personal life could affect which mortgage is better speak to us and pick the right mortgage to save you money.

It is a good idea to get a quotation based on both options and consider the right one for you. 

Interest Only

The advantages and disadvantages of interest only mortgages:

• The way the mortgage is repaid is less easy to understand.
• The cost of the actual mortgage will be cheaper than on a repayment basis.  However, once the costs of any savings or investment plan have been added in, the overall cost of an interest only mortgage could be higher.
• At the end of the term you will still owe the amount you borrowed. 
• It is important to be able to repay that amount from the savings vehicle taken out.  Unless you have taken out a savings vehicle that guarantees your mortgage will be repaid at the end of the term, the lump sum available will generally not be known. 
• There could be a shortfall or surplus based on the amount you need.
• This type of mortgage may not be suitable for people who do not want any risk related to the repayment of their mortgage.
• Life insurance may be included in the savings vehicle or you may need to take out separate life insurance so that the mortgage can be repaid in the event of death.
• You should have a full choice of mortgage schemes such as fixed, discount and capped rates.

Repayment

The advantages and disadvantages of capital and interest, repayment mortgages:

• The way the mortgage is repaid is easy to understand.
• This method is possibly cheaper than borrowing on the interest only basis.
• The amount you borrowed reduces to zero at the end of the term.You are paying off capital throughout the term so you will owe nothing at the end, as long as you have paid the amount that the mortgage lender told you to, on the correct date.
• As long as payments are made correctly and on time there is no risk of this mortgage not being repaid. 
• This type of mortgage could therefore be suitable for people not wanting to take any risk with the repayment of their mortgage.
• This repayment method can be cost effective if enough life insurance and other financial products are already held.
• Capital and interest repayment mortgages are easy to top up and take on additional loans, as long as you still meet the mortgage lender's lending criteria.
• You should have a full choice of mortgage schemes such as fixed, discount and capped rates.
• Depending on your age and state of health, insurance just to cover a mortgage is usually very cheap and will pay off the outstanding mortgage should you die within the mortgage term.

Overview:

If you need to know that your mortgage will be repaid at the end of the term you may be more likely to opt for a capital and interest repayment mortgage.  Remember that the balance at the end will only be zero if you have made payments on time and at the correct amount.  This way, repayment of the mortgage does not rely on financial products.  

If you like the idea of just repaying interest and then the lump sum of capital at the end of the term, an interest only mortgage could be suitable.  It is important to understand the unknown element of an interest only mortgage because what you get back at the end from your savings or investments may not be enough to repay the amount you borrowed.  On the other hand, you may have more than enough to repay the mortgage.