Interest-only vs repayment

An interest-only mortgage may look extremely attractive, especially when you could be saving around £175 per month on a £100,000 mortgage. However, FTB advises to arm yourself with the facts before opting out of a repayment product

There are three main types of mortgage - interest-only, repayment and flexible offset mortgage - and the best one for you will depend on your individual circumstances. Melanie Bien, director of independent mortgage broker Savills Private Finance, explains: "With a repayment mortgage, you repay some of the loan capital and interest every month. The idea is that if you keep up the repayments, by the end of the mortgage term you will have cleared all the capital and own the property outright. With an interest-only loan you pay only the interest each month and still owe the initial amount borrowed at the end of the term."

Bien adds that a repayment mortgage will always be the most cost-effective option in the long term: "In the early years of the loan, you pay hardly any of the capital back - it is mostly interest. As time passes and your debt reduces, your monthly payment is made up of more capital than interest. Towards the end of the mortgage term you are therefore clearing the capital much more quickly than you are at the start. It is not until around halfway through the term that you are paying roughly the same amount of capital and interest each month."

An interest-only mortgage can prove popular with first time buyers over the short-term. Itis possible to begin homeownership with an interest-only mortgage to keep the monthly payments down and your outgoings more affordable, especially if you will be getting a pay rise in the near future. When your income does increase it is wise to then switch to a repayment mortgage, although it is worth finding out from the lender if this will incur a fee.
If you only plan to be a homeowner for a short space of time, due to planned relocation for example, it is not worth investing in a repayment mortgage. "If you do buy a property for only a couple of years and take out a repayment loan you will only really be paying the interest over that period so in that respect an interest-only deal may be more suitable," advises Bien. However, she adds that, "In this market in particular, it is unwise to buy a property for a short period of time. Property should be held for the long term - several years at least - because prices are so volatile."

If the plan is to take out an interest-only mortgage for a longer period, many lenders and mortgage advisers insist on having a separate investment vehicle, which pays off the capital of the loan over time; this can be more tax efficient than simply having a repayment mortgage.

Neil Young, CEO of Young Finance, advises: "For first time residential purchasers, the important thing to remember is that if an interest-only mortgage is taken out, it must be accompanied by a separate investment - for instance an ISA - which will run alongside it to act as a 'repayment vehicle'. Without it, the client has no way of paying back the amount of capital that has been borrowed."

Bien agrees, but adds that an investment vehicle can prove extremely risky: "Endowments are now largely out of favour but borrowers often use individual savings accounts to pay off the capital. However, cash ISAs are unlikely to generate enough in returns because of the low interest-rate environment, so you will need to look at the stock market, which is volatile. There is no guarantee that whatever investment vehicle you choose will generate enough cash to pay off your capital."

Most lenders allow you to overpay by up to 10% of your outstanding mortgage per year without an early repayment penalty. Paying a lump sum off of your interest-only mortgage can especially useful if you get bonuses through work or are expecting a windfall or inheritance.

During the current economic climate, it has become extremely tempting for those starting out to opt for an interest-only mortgage and, instead of looking at a repayment vehicle, rely on an increase in property value. The average house price is over four times the amount it was 25 years ago, and many people may be in a better position to pay off a loan in the future due to inflation and better incomes.

However, Bien warns that this way isn't cost effective and carries its own risks: "Over the past 25 years or so, property prices have increased at an incredible rate so homeowners have easily been able to clear relatively small mortgages. But borrowers should not assume this will happen again."

Due to the risk involved the Financial Services Authority (FSA), who regulates mortgages, has not made it compulsory to run an investment vehicle alongside but have urged lenders to make sure that their customers have a way of paying the capital in place. "The FSA is increasingly cautious in regard to its guidance on interest-only mortgages, particularly for first time buyers, stipulating that pure interest-only mortgages should not be recommended and that evidence of a repayment vehicle should be required," explains Young.

Bien agrees: "Since the credit crunch took hold, lenders have become stricter with regard to interest-only loans. For example, Abbey will only allow borrowers up to 50% loan-to-value if the deal is interest-only or up to 75% if the customer has a repayment vehicle in place. Halifax now insists on evidence of a repayment vehicle before agreeing to interest-only. It really depends on the lender."

If you're still undecided about whether to go interest-only or repayment, there are other mortgage products which are aimed at those looking for somewhere in between. Many banks, including Abbey, are offering a part-repayment, part-interest mortgage. Borrowers may also be interested in opting for a flexible offset mortage, which is similar to a bank account and allows money to be withdrawn or deposited against the amount of the mortgage. Abbey offers a flexible product of up to 75% LTV, which is currently priced at base rate plus 3.25% with a fee of £1,495.

CASE STUDY - Compare mortgages

Bob needs a £100,000 mortgage, which he plans to pay off over a 25-year period. For this example, we have assumed the interest rate will remain at 5% throughout the term.

Interest-only:
On an interest-only mortgage at 5% interest, his monthly repayments are: £416.66. The total cost of interest over 25 years (300 months): £125,000. However, he will still owe the initial capital: £100,000. To pay off the property, he will need to pay: £225,000 (interest and initial capital).

Repayment:
On a repayment mortgage at 5% interest, his monthly capital and interest payments are: £591.27. The total cost of interest and repayment over 25 years (300 months): £177,381 (of which £100,000 is initial capital and £77,381 is interest).

Saving:
In total Bob will save £47,619 in interest payments if he goes for a repayment rather than an interest-only mortgage.

Why?
On an interest-only mortgage, Bob is paying interest on the whole £100,000 capital he borrowed throughout the term of the mortgage.

On a repayment mortgage, Bob is paying off the £100,000 initial capital over the 25-year period and therefore chipping away at the capital over time. Rather than paying interest on £100,000 for the entire term, Bob only needs to pay interest on the amount of capital outstanding, and as this diminishes over time, the interest he pays will be much lower than an interest-only mortgage.

For a repayment mortgage, the lender will spread the total mortgage cost (capital and interest) over the 25-year period. The mortgage will initially be made up of mainly interest payments then towards the end will be mainly capital repayments.