Paul Wheatcroft, 18 months ago18 min read
Whilst the UK mortgage market is awash with different loan types, there is a foundational decision that needs to be made at the start of the journey; should you take out a mortgage on an interest only or repayment basis?
These two payment models are commonly talked about by lenders and mortgage advisors, however unless you’ve got experience with mortgages these terms might sound like financial jargon. How you repay your mortgage is often the fundamental building block of longer term financial planning, so it’s critical that borrowers understand the difference between the two models and how they impact your finances.
In this article we set out to explain the meaning of ‘repayment’ and ‘interest-only’ mortgage models, and help you understand the benefits and risks to each option.
While we hope that you find this information useful, it shouldn’t be used as a substitute for regulated financial advice. To speak with a mortgage advisor and discuss which option is right for you, you can book a free same-day consultation here.
Anyone who has taken out a standard loan for a holiday, car purchase or a bit of home improvement will understand the mortgage repayment model. The amount you borrow is split across the term of the loan (the amount of time you intend to pay the loan back over, usually 25-40 years for a mortgage), and repaid back monthly alongside the interest the bank charges you for borrowing the money (the lender’s ‘interest rate’, or ‘mortgage rate’)
To give a simple illustration of a repayment mortgage:
You borrow £250,000 over a 30 year term to buy a £300,000 property (with a £50,000 deposit), at a fixed interest rate of 3.25%
Your monthly repayments would be £1,088
Over the course of 30 years you’ll have paid back £391,680, which consists of repaying the original £250,000 loan, and £141,680 in interest paid to the lender.
Most borrowers are very comfortable with this traditional loan repayment model, and the majority of UK home loans are written this way. Whilst it can sometimes be shocking to see the total interest you’ll pay to a lender over the lifetime of your mortgage, this is still very low-cost lending and allows home ownership to be a possibility for millions of people in the UK.
Assuming you’re able to keep up your mortgage payments over the lifetime of your loan, there are few risks to a repayment mortgage. The balance you owe gradually declines, and once the mortgage is cleared then you own your home mortgage free.
There are typically only two criticism you hear of the traditional repayment method:
1) Tax Inefficiency: As your mortgage payments are made with the money left in your paycheck after tax, the amount you need to earn as a salary is much higher than the mortgage payment itself.
For example, if you paid tax and National Insurance at an overall rate of 30%, to earn the £1,088 needed for the monthly mortgage payment in the illustration above, you would need to earn a salary of £1,554 (once your tax is deducted, you’re left with the £1,088 for the mortgage payment). This means an annual mortgage cost of £13,056 would leave you needing to earn £18,648 in salary to cover the post-tax payments.
To take that one step further using the illustration above; to cover the £391,680 needed over the lifetime of the mortgage, you would need to earn £559,543, as follows:
In the UK there are allowances for pre-tax savings (in the form of a pension), and there’s an argument that mortgage planning can be more economical if rather than repay your mortgage with post-tax earnings each month, you save the equivalent amount in pre-tax pension savings with the intention of clearing your mortgage at retirement age.
2) Opportunity Lost: Mortgage lending is undoubtedly the cheapest debt available to consumers in the UK, and there’s a school of thought from borrowers with a higher risk tolerance of ‘why rush to pay back cheap debt, when the money can earn you more elsewhere?’
For example, if you were to borrow the £250,000 mentioned in the illustration above at a rate of 3.25%, but rather than repay the loan balance each month you were to put the repayment amount into a FTSE 100 tracker fund (which has historically delivered a total growth rate of 7.8%)
In this example, each year you would be paying the lender interest of £8,125 but you would be earning more than double in equivalent growth. Over a 30 year period this excess would compound to £557,618 in savings, allowing you to clear the outstanding £250,000 mortgage balance with a handsome sum to spare and help fund your retirement.
Of course, that’s highly dependent on investments continuing to perform as they have historically, which poses a potentially critical risk for anyone embarking on this approach. Due to these risks, this strategy would only be suitable for a small number of borrowers (typically those that have other funds available to pay back the mortgage amount if their investments did not pay off). We would urge anyone considering taking this kind of route to spend time with an experienced financial advisor to ensure there is a robust and secure plan in place.
Whilst neither of these issues may keep the average borrower awake at night with worry, for some they are worth considering when completing a financial planning exercise. Managed right, optimising your financial strategy for tax efficiency and growth opportunities can potentially make your money work much harder for you, with the cumulative impact being tens (or even hundreds!) of thousands over the lifetime of your mortgage.
Whilst simply paying back the loan plus interest in monthly installments is the most common mortgage repayment method, alternative routes have become increasingly more commonplace over the last few decades, and there are millions of UK borrowers who chose to pay their loan on an ‘interest only’ model.
As the name suggests; using this method the borrower only pays the interest rate charged by the lender, choosing not to pay back the actual loan amount until the end of the 25-40 year mortgage term.
To illustrate this using the same numbers as the repayment mortgage:
You borrow £250,000 over a 30 year term to buy a £300,000 property (with a £50,000 deposit), at a fixed interest rate of 3.25%
Your monthly repayments on an interest only basis would be £677
Over the course of 30 years you’ll have paid £243,835 in interest to the bank, and you will still owe the original £250,000 you borrowed.
So the same house purchase as the repayment model results in much lower monthly mortgage payments (£411 less per month), however at the end of the 30 year period you would still owe the bank the full £250,000 you borrowed. If you were to then repay the original loan, the total cost of this mortgage would be £494,835 (£103,155 more than the repayment loan)
Looking at these two options side-by-side, it may seem hard to make a case for an interest-only mortgage. However, there are several situations where borrowers could potentially benefit from taking an interest-only mortgage. These include:
1) When a borrower has a separate savings vehicle which they use to invest the monthly savings they make on the interest-only mortgage. As there are tax-efficient saving wrappers such as pensions and ISAs, it can work out more financially beneficial to save up separately each month and pay the mortgage off in a lump sum (especially if you can earn a growth or interest rate higher than your mortgage rate)
For example, using the numbers from the illustration above:
If a borrower were to save £411 a month in an investment account that tracked the FTSE 100 (which has historically delivered average annual returns at 7.8%), over the 30 year mortgage period they would have accumulated £557,618 in savings.
This means at the end of the interest-only mortgage period they could clear the £250,000 loan and still have £307,618 left in savings. This would make the net cost of the mortgage £85,177, £306,503 cheaper than the repayment mortgage!
This saving is before the tax benefits of a pension, ISA or other vehicle are taken into account, which could make the numbers even more favorable to the borrower.
Of course it’s absolutely key to note that there are critical risks to any financial plan that involves a reliance on investments, and it’s essential that any borrower considering using a savings vehicle to cover their mortgage balance seeks professional financial advice.
2) When a borrower is due a lump sum payment at some point in the future that will comfortably cover the balance of a mortgage. For example, if you know there is a large inheritance due to come to you following the death of a family member or loved one which you intend to use to pay off your mortgage.
In this scenario, it may make sense to avoid stretching yourself with the larger monthly payments on a repayment mortgage, and instead taking an interest-only mortgage to reduce your short-term outgoings safe in the knowledge that the final balance of the loan (the original amount you borrowed) will be covered in the future.
Again, this approach is not without its risks as there could be issues that impact the amount you receive in the future (for example, potential future tax changes could result in an inheritance payout being smaller than you expected)
3) When a borrower needs to temporarily reduce their monthly mortgage payments. This could be due to a change in circumstances that mean that your income or affordability are temporarily impacted, such as a stint of unemployment or reduced income due to maternity/paternity leave.
While it’s not guaranteed, lenders will potentially allow borrowers to switch a repayment mortgage to interest-only in order to reduce payments. Using the illustration from above, a borrower on a repayment mortgage paying £1,088 per month could temporarily reduce their monthly payments to £677 during a period of reduced income or increased expense, saving £411 per month.
The big downside of this is it means that the mortgage balance isn’t being reduced during this temporary interest-only period, so there will likely be larger payments needed to clear the loan balance when the borrower moves back to a repayment method.
A responsible lender will still need to ensure affordability of these reduced payments, so borrowers should expect any request to switch to an interest-only mortgage to come with a deep-dive into their earnings and expenses.
One key point to note here is that the decision to choose a repayment or interest-only mortgage vehicle isn’t necessarily a permanent one. Over the 25-40 year lifespan of a mortgage it isn’t uncommon for borrowers to change the repayment method depending on their circumstances, and often lenders will work with borrowers if these circumstances change. It’s good to set out with a repayment strategy in place, but it doesn’t necessarily mean it can never be adjusted.
4) When a borrower plans to sell the property and use the proceeds to clear the mortgage balance. This is often the case with mortgages on second homes or buy to let properties, where the borrower doesn’t intend to keep the property into old age.
This is less likely to be an effective strategy for residential mortgages where the borrower intends to live in the property for the remainder of their life, as the loan balance will still need clearing at the end of the mortgage term. In this scenario if the borrower is intending to sell the property to clear the mortgage then they could potentially be in the difficult position of needing to find a new home when they are near or past retirement age, where it could be difficult to obtain a new mortgage or enter the private rental market on a pension income.
Even in the case of a second home or a BTL property, this approach isn’t risk free as it’s reliant on property prices maintaining at least the value they were purchased at. If property values were to fall, then a borrower could be left in the position where they sell the property and don’t receive enough funds to clear the mortgage balance.
While these are some broad scenarios where an interest-only mortgage may be a better option, there are specific details and nuances within each circumstance that will impact how beneficial this option will be for an individual borrower. As ever, our strong recommendation is to seek independent financial advice to review your circumstances and decide whether an interest-only mortgage is right for you.
To book a free, no-obligation, consultation book a call with our partners at Fluent Mortgages.
To understand the risks of an interest-only mortgage, a short history lesson is required. Prior to the 2008 global financial crash (largely driven by poor lending practices in the mortgage industry), interest-only mortgages were a mass-market product with a huge consumer demand.
This loan model allowed borrowers to purchase properties that would have been out of their price range on a repayment model, however the lower monthly payments on an interest-only model meant affordability went further and bigger loans could be given.
In 2007, prior to the financial crisis, the Bank of England recorded that 42% of all new mortgages written were on an interest-only basis. To understand how badly it went wrong; nearly ten years later in 2016 just 7% of new lending was on an interest-only model.
So what happened? Well the answer to this question highlights the ultimate risk with an interest only mortgage; at the end of the loan term, what if there aren’t enough funds to clear the mortgage balance?
Following the 2008 crash thousands of borrowers were left with this exact dilemma, with the cause typically falling into three categories:
1) They had no plan for repayment. Modern lending regulations mean that lenders must ensure a borrower has a clear repayment plan to pay the mortgage balance when the term ends on an interest-only mortgage. However, historically these regulations were not in place and many borrowers were sold interest-only mortgages simply on the basis of cheaper monthly payments, with no real plan for longer term repayment.
In the industry this has been referred to as the ‘interest only time bomb’, as there are borrowers whose terms are heading to an end with no plans or means to pay back the balance. In this scenario, a borrower’s only option may be to sell the property and hope there’s enough equity to clear the loan and leave enough excess for an alternative housing solution.
2) The repayment plans fell short. In the 1990’s there were hugely popular ‘endowment’ products available. These were effectively interest-only mortgages that had a linked investment product, with the intention of the investments growing large enough to cover the mortgage balance and hopefully providing an excess for the borrower.
Unfortunately, many of these products not only failed to provide an excess, they struggled to even match the initial loan balance. This meant that when the mortgage term came to an end the borrowers owed the lenders more money than they had available, and they had to find a way to repay the difference.
Whilst you don’t hear of endowment products in the current mortgage market, there are still borrowers who intend to clear the balance of an interest-only mortgage using a separate savings or investment vehicle. Whilst this can be a beneficial model if the savings grow at the expected rate, there are thousands of borrowers who are a living testimony to the risks of this model.
3) The property values fell. Along a similar vein to the previous issue; many borrowers have faced issues with interest-only mortgages when the repayment vehicle has failed to cover the outstanding loan balance at the end of the mortgage term. However in this case; the repayment vehicle is the property itself.
For example, if you were to take out an interest-only mortgage on a £200,000 property on a 90% LTV, which would mean a loan of £180,000. If the plan was to sell the property when the mortgage term ended and use the funds to clear the loan balance, you are reliant on the property being worth at least £180,000
Whilst property prices have historically trended upwards, there have been periods of downturn where prices have stepped backwards. There’s no crystal ball to say when the next downturn may happen, and if it conceded with the end date of an interest-only mortgage then a borrower could find themselves in a situation where the proceeds of a sale don’t cover the outstanding mortgage balance due, in which case they would be liable to pay the difference.
It’s essential that modern borrowers learn from the mistakes of the past, and whilst there are now regulations in place to help derisk the above issues, these risks do still exist. Any borrower looking to take out an interest-only mortgage should have a clear and robust plan to pay back the loan balance at the end of the mortgage term, and ideally a back-up solution if this plan where to fall short (for example; back-up savings that would cover any shortfall if the property price fell below the balance value)
We’ve discussed the details and benefits of both repayment and interest-only mortgage methods, as well as the downsides and risks posed with each option. We hope by this point you’ve got a much better understanding of the two methods, and you may be asking yourself which option is better for you.
The key thing we are eager to stress is that the benefits and risks of each option are highly dependent on your personal situation and longer term plans, as it’s very rare that two borrowers have the exact same circumstances. Therefore, we would recommend speaking with an experienced financial advisor who will be able to spend the time to understand your circumstances and advise on which route is best for you.
Some of the areas a good financial advisor would want to look at include:
- Your current earnings and expenses, and how your career and family plans will impact these in the future. For example, if you are planning on having children or making a career change, it’s likely that your balance of earnings and expenses will change
- Your wider financial plans including savings and investments you have previously made or are budgeting to make in the future. For example, if you have always invested heavily in your pension and intend to continue doing so, it may change the advice you are given when taking out a mortgage
- Your retirement plans, and how this will impact your living situation. Typically a mortgage term (25-40 years) would roughly coincide with a borrower reaching retirement age, and therefore the financial advice you receive will be impacted by your plans for retirement. For example a borrower who intends to remain in a property for the remainder of their life will likely receive different advice than someone who intends to sell-up and move abroad.
- Your risk tolerance, which is the industry term for measuring how comfortable and prepared you are to take financial risks. Someone with a low risk tolerance is likely to receive different financial planning advice than someone who has a higher tolerance for risk
To find independent and professional mortgage advice, just input your postcode in our handy tool and find Mortgage Advisors available in your area. Alternatively, you can arrange a free consultation today with our partners at Fluent Mortgages.