One of the main costs that you need to consider when taking out a mortgage is the interest rate. Your mortgage lender will charge interest on the sum you borrow, and as a result, the amount you end up repaying will be more than the initial sum you borrowed.
The higher the interest rate, the more the loan will cost you overall.
There are two main ways in which the interest can be charged on your loan, and it’s crucial that you understand the differences as it will have a big impact on the size of your monthly repayments.
How does a repayment mortgage work?
With a traditional repayment mortgage, your monthly mortgage bill will be made up of two parts. Some will go towards repaying the initial sum you borrowed while some will cover the interest charged on the loan.
You take out your mortgage over a specific term, for example 25 years. With a repayment mortgage, once you make that final monthly payment, the mortgage will have been repaid in its entirety. At this point you own the property outright.
How does an interest-only mortgage work?
As the name suggests, with an interest-only mortgage your repayments are a little different: the amount you pay each month only covers the interest charged on your loan.
Like a repayment mortgage, the loan is taken out over a specific term. But when you reach the end of the term, you still need to pay off that original sum you borrowed in the first place as you have only been paying off the interest each month. If you are unable to do so, then you may have to sell your property.
Pros and cons of repayment and interest-only mortgages
The big positive of an interest-only mortgage is that your monthly repayments are inevitably going to be smaller as you are only paying off interest each month.
However, it’s also worth bearing in mind two things with interest-only mortgages. Firstly, not all lenders offer their products on an interest-only basis, and secondly, if they do, it is likely to only be on a proportion of the borrowing required, with the remainder on repayment. So if you are determined to borrow in this way you may face a more limited range of options. As they are considered higher risk you may also need to stump up a bigger deposit.
Of course, the money you’ve borrowed still has to be repaid, and this is undoubtedly the biggest headache with interest-only mortgages. Lenders will want to have an idea of how you plan to repay it before even offering you the loan on these terms ‒ this could include endowment policies, investments or even the sale of a second property. A lender may ask for updates on how your planned repayment vehicle is getting on over the course of your loan too, to ensure that you don’t get to the end of the loan with no idea of how to pay it off.
A repayment mortgage is far more straightforward. While you will have to stump up a larger sum each month towards repaying your loan, you at least have the certainty that once you get to the end of your mortgage, it is paid off in full and you own your property in its entirety.
Most residential borrowers use repayment mortgages, but interest-only mortgages are used more frequently in the buy-to-let market, where owners view the property as an investment they can intend to sell to repay the loan. Talking to a mortgage adviser can help you decide whether a repayment mortgage or an interest-only mortgage is best for you.
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Combining the two
Residential lenders most likely require you to mix and match and go with a part interest-only mortgage. This is a combination of the two main options, and means that your monthly repayment covers the interest charged on your loan and some money towards the initial loan.
This method means smaller bills than a full repayment mortgage, but you will still need to pay some of the loan off when you reach the end of the term. Again, lenders will want to have some idea of how you plan to do this.
Can I switch to a repayment or interest-only mortgage later?
Borrowers may be able to move from a repayment mortgage to an interest-only deal, or vice versa, during the term of their mortgage, but this will very much depend on the type, size and individual circumstances of the loan.
If you are moving from interest-only to repayment, then the lender will want to run over your finances to check you can afford the higher monthly bills.
Not all lenders will consider moving you to interest-only payments from repayment. Those that do will expect you to demonstrate precisely how you plan to pay off the actual loan sum once you reach the end of your term.
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