Should I get a ‘Repayment’ or ‘Interest Only’ mortgage?

from www.confused.com 

First things first: There is no such thing as an “interest only” mortgage! A provocative assertion, I know. So, strictly speaking, I suppose I should say: there is no such thing as an “interest only” loan. 

The mortgage itself might be interest only. But the capital element doesn’t just disappear. It’s repayable at the end of the mortgage term and you’ll need to be paying into a separate savings plan (such as an ISA) from which you’ll eventually have to make that repayment. And that’s the difference between the two types of mortgage, of course?

Repayment Mortgage

With the straightforward, “old-fashioned” repayment mortgage, your monthly repayments contain an element of both interest and capital repayment (the proportion of interest to capital gradually declining as the amount of the outstanding loan diminishes over time). 

With a repayment mortgage, it’s good to know that when it comes to full term, you’ll have paid off the entire debt. 

Furthermore, if you want to shorten the life of the mortgage and reduce its cost, any increase in monthly repayments will go towards both the interest and capital elements of the loan. So, the repayment mortgage keeps the whole of the loan in one place, and tends to offer you greater flexibility in response to changing personal circumstances.

Such security and peace of mind comes at a price. Monthly repayments tend to be higher than those on an interest only mortgage together with its associated capital savings plan. The repayment mortgage lender may also make it a condition that you take out a mortgage protection policy, which guarantees repayment of the outstanding loan in the event of the mortgagee’s death.

Interest Only Mortgage

If the monthly commitment demanded by a repayment mortgage is too steep for you, then it’s certainly worth investigating an interest only mortgage and an associated investment or savings plan.

By paying less, however, you should be clear that you are also assuming a greater part of the longer-term risk. In this instance, the investment or savings plan that you open to provide the capital repayment on the full term could succeed very well and pay for the capital loan, and also leave you with a handsome cash bonus. 

On the other hand, if your investment scheme fails to deliver as promised, you could be left without enough to repay the capital loan and still owe money on the property – even when the mortgage payments have finished.  Basically, the mortgagee should continually assess the rate of interest for the product they are investing in to gauge a return, and be fully aware that interest rates can go up as well as down over the life of the investment.

For prospective landlords, an interest only mortgage not only offers the benefit of cheaper repayment terms, but also potential tax advantages. An expenditure the landlord can offset against rental income is the interest he needs to pay on his loan. He cannot offset the capital element of his repayment mortgage, on which the interest element will be steadily declining over the years. It may be to his advantage, therefore, that the interest only mortgage offers a constant rate of interest, and a constant source of expenditure against which to offset rental income, throughout the life of the mortgage.

Summary:

A repayment mortgage can be great for people who want the peace of mind that at the end of the mortgage term their debt, including interest, will be paid off in full.

An interest only mortgage may be suited for, in the first place, landlords. But interest only might also be the logical choice for people who cannot afford to pay off the interest and capital on the borrowing, but who have a suitable savings vehicle to clear the capital at the end of the term.

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