Repaying a mortgage is one of the most important considerations when taking out a loan to buy a home. In the United Kingdom, you can choose between an interest-only mortgage or a repayment mortgage. With an interest-only mortgage, monthly payments cover only the interest on the loan, making the payments more affordable. In contrast, a repayment mortgage involves paying back a portion of the principal loan amount along with interest, resulting in higher monthly payments.
Which option is best for you? Keep reading to find out.
Repayment Mortgage
In this type of homeowner’s loans, the monthly payment has two parts: the first part covers the interest on the loan, and the second part goes towards reducing the principal amount. This means that a portion of the monthly payment is used to pay off the loan till the end of the loan term, which is generally about 25 years. By the end of the homeowner’s loan term, you will attain the home-ownership.
How does it work?
When you take out a repayment homeowner’s loan, every monthly payment consists of two parts – payment towards interest and the amount you have borrowed from the lender. In the initial few years, the major proportion of the payment covers the interest rather than the principal amount. However, with time, the interest amount you owe decreases.
Therefore, in the last few years, the major portion of the monthly payment has been utilised to clear off the outstanding principal amount. In some cases, if you have some extra cash available, you can increase the monthly payments to pay off the debt faster. You also have the choice of repaying the mortgage amount by either going for the fixed- or variable-rate of interest.
Let’s understand a repayment homeowner’s loan with a hypothetical example.
Let the loan term be 25 years, the loan amount £200,000, the interest rate 3%, and the monthly payment be £948.
| Year | Monthly Payment (£) | Interest (£) | Total Amount Owed (£) |
| 0 | 948 | 494 | 200,000 |
| 1 | 948 | 480 | 194,543 |
| 5 | 948 | 436 | 171,006 |
| 10 | 948 | 353 | 137,328 |
| 15 | 948 | 257 | 98,211 |
| 20 | 948 | 145 | 52,775 |
Pros & Cons
| Pros | Cons |
| At the end of the homeowner’s loan term, the property is fully owned by you.As the principal balance decreases, the interest you pay also decreases.Over time, the decreasing balance may help you qualify for better deals due to a lower loan-to-value (LTV). | Monthly payments are higher compared to an interest-only mortgage.It takes time before the principal amount significantly decreases. |
Interest-only Mortgage
The monthly payment in this loan type covers only the interest. Therefore, the payable amount each month is comparatively low. However, the principal amount or the amount you got as a loan remains as it is. In the example above, by the end of the loan term of 25 years, your outstanding debt remains the same at £200,000. You will have to arrange for this amount to pay off your debt. You will most probably need to submit the proof of a repayment plan to the lender to get this homeowner’s loan. You will also need to deposit a tangible amount to be considered eligible for the interest-only homeowner’s loan. This condition, of course, does not apply to a buy-to-let loan.
How does it work?
With this loan type, the monthly payment only covers the interest. As a result, the monthly payment is lower compared to a repayment homeowner’s loan for the same loan amount.
For example, an interest-only loan with a £200,000 loan and a 3% interest rate over 25 years would require a monthly payment of around £500. This is nearly £450 less per month than a repayment homeowner’s loan. A smart approach is to save this difference and deposit it into a separate repayment plan, helping you accumulate the funds needed to pay off the principal at the end of the loan term.
As mentioned, you will need to submit a repayment plan to show how you intend to pay off the loan at the end of the term.
| Year | Monthly Payment (£) | Interest (£) | Total Amount Owed (£) |
| 0 | 500 | 500 | 200,000 |
| 1 | 500 | 500 | 200,000 |
| 5 | 500 | 500 | 200,000 |
| 10 | 500 | 500 | 200,000 |
| 15 | 500 | 500 | 200,000 |
| 20 | 500 | 500 | 200,000 |
Pros & Cons
| Pros | Cons |
| Monthly payments are less than those in a repayment mortgage.Potential for profit if the investment (e.g., property) outperforms expectations.Extra cash is available for other purposes, such as home improvements.You may be able to borrow a larger amount, making it easier to afford a more expensive home | The original loan amount must be repaid in full at the end of the term.The total interest paid may be higher than with a repayment mortgage, as interest is charged on the original principal, which does not reduce.You need a solid investment or savings plan to repay the principal at the end of the term.A larger deposit and potentially higher income are often required to qualify for an interest-only mortgage.Interest-only mortgages are less common than repayment mortgages.If your repayment plan fails, you may need to sell your home or use personal savings to repay the loan. |
Comparing Repayment vs Interest-Only Mortgage
The table below compares both the loan types for a £250,000 loan at a 5% interest rate for a 30-year term.
| Repayment Mortgage | Interest-Only Mortgage | |
| Monthly Payment | £1,343 | £1,042 |
| Total Interest paid across full-term | £233,340 | £375,271 |
| Total amount over the full term (Interest + original loan amount) | £483,340 | £625,271 (the original amount of £250,000 including) |
Repayment vs Interest-Only Mortgage: Which is best for me?
For many borrowers, interest-only homeowner’s loans may seem more appealing due to their lower monthly payments. This is because the monthly payment only covers the interest, while in a repayment homeowner’s loan, the payment includes both the interest and a portion of the original loan amount.
However, with an interest-only mortgage, the total interest paid over the term is higher, and the principal loan amount remains outstanding by the end of the term. If you have a clear repayment plan and can convince your lender, an interest-only homeowner’s loan can be a good option. This plan might involve investments, the sale of another property, or endowment policies. Keep in mind that lenders will often request regular updates on your repayment strategy to minimize their risk.
In contrast, a repayment mortgage is more straightforward. While monthly payments are higher, the advantage is that by the end of the homeowner’s loan term, the property will be fully owned. Additionally, the overall interest paid is typically lower.
When choosing between the two, consider your financial situation and long-term goals. Most residential borrowers opt for repayment loans, while those looking to invest in buy-to-let properties often prefer interest-only mortgages.
Switching between the two mortgage types
Is it possible to shift between the two? You can do so, but you will need your lender’s approval. But here are certain things to remember –
- When shifting from an interest-only to a repayment homeowner’s loan, you must prove your ability to pay the higher amount each month.
- When shifting from a repayment mortgage to an interest-only deal, you should have a repayment plan to pay off the principal amount at the end of the loan term.
Remember, homeowner’s loan lenders will execute a detailed approval process, especially in the repayment mortgage case, as the monthly payments are higher.
Upfront, if you plan to buy your own home, a repayment mortgage is a better choice as it is cheaper. However, if your income is high and you can afford a large mortgage deposit (almost half of the property’s value), many lenders may offer you an interest-only deal.
That’s why interest-only mortgages are offered mostly for buying buy-to-let properties, which are more like investments. Owners can sell the property to pay off the original amount.
Need help deciding whether an interest-only or repayment mortgage is best for you? Speak with us at Cangaf Accountants.
FAQs
- What happens at the end of the interest-only mortgage?
At the end of an interest-only mortgage, you will need to repay the entire original loan amount in one lump sum. To do this, you can use savings, access your pension fund, sell a property, liquidate stocks and shares, or take out another mortgage. It’s essential to have a clear repayment strategy in place before the term ends.
- What is the purpose of an interest-only mortgage?
Interest-only mortgages have a lower monthly payment, and many people want to take advantage of this. This may make the entire process of buying the property more affordable, at least initially.
- Is interest-only mortgage the best option for buy-to-let properties?
Most property investors prefer interest-only mortgages due to the lower monthly payments that reduce the cost of owning the rental property. Additionally, they have the option of selling the property to pay off the loan amount towards the end of the mortgage.
Loan Charter – GOV.UK: This document outlines the commitments of lenders to support borrowers, including options to switch between repayment and interest-only loans.
Support for Mortgage Interest (SMI): Overview – GOV.UK: This page explains the Support for homeowner’s loan Interest scheme, which can assist with interest payments on loans, and discusses options like temporary payment holidays and interest-only payments.
Changes to Tax Relief for Residential Landlords: How It’s Worked Out – GOV.UK: This guidance details how tax relief is calculated for landlords, including examples that illustrate the impact of interest deductions on both interest-only and repayment mortgages.
