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Interest only vs repayment mortgages

Interest only or repayment mortgages

There’s all sorts of jargon to get to grips with when considering mortgages, but one of the most crucial matters to grasp is the difference between an interest-only and a repayment mortgage.

What is an interest only mortgage?

An interest only mortgage is where you only repay the interest on the loan each month, rather than paying off the money you borrowed. This means at the end of the mortgage term you still owe the full amount that you originally borrowed and so you will need to ensure you have a way of paying off the entire mortgage all in one go at the end.

What is a repayment mortgage?

With a repayment mortgage, on the other hand, you pay interest charges each month but also make a small repayment of the original advance. At the end of the term of the mortgage – usually 25 years – as long as you have kept up repayments, you’re debt-free with no more to pay.

Interest only mortgages are more risky

So which type of deal is best? Well, there’s no right answer to that question – it really depends on your attitude to risk.

With an interest-only loan, the additional savings you make are invested in order to get you to the final total required. The returns on these investments plus, very often some tax breaks, may mean repaying the capital borrowed costs you less in total monthly contributions. And on the day the mortgage finally falls due, you may even find you have additional cash left over – a lump sum to spend as you see fit.

Interest-only mortgages got a bad name during the endowment scandal. Many borrowers were sold endowment funds they thought were guaranteed to repay their mortgages, only to find many years down the line that they actually faced a shortfall.

That is the risk of an interest-only mortgage. If the investments you make disappoint, you may not have enough money to cover your debt. In which case you’ll have to make additional payments you weren’t expecting.

In practice, such a shortfall should not come as a horrid last-minute surprise. If you do opt for the interest-only route, your mortgage lender will expect to see evidence that you are making provisions to repay the capital. And the provider of the savings vehicle you are using should provide you with regular updates on your progress – including warnings if it thinks you are in danger of falling short of the sums required (and advice on what to do to make up the ground).

Moreover, you may be able to get a little extra help from the taxman. If you use tax-efficient saving products to save for the final payment, such as individual savings accounts or even pension schemes, you’ll get a boost from their tax-free status.

Fewer interest only mortgages available

Even so, interest-only products are not for the faint-hearted. Where interest-only mortgages sold with an endowment policy were once the most common type of home loan, the majority of people these days prefer the security of a repayment mortgage.

Many lenders have also decided to stop offering interest-only mortgages or will only offer them to certain customers. So the range of mortgage deals available to you may be more limited if you opt for an interest only mortgage. A Which? Mortgage Adviser will be able to advise you on whether an interest only mortgage is the right option for you.

There are other things to consider too when you’re looking to get the best mortgage deal. You should also think about whether you would like a fixed rate mortgage or a variable rate mortgage.

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