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Comparing a conventional repayment mortgage to an interest-only mortgage is a little like comparing apples to oranges. Both have their benefits and points of appeal, though they are completely different in nature.
For most people, the prospect of taking out an interest-only mortgage does not seem realistic. The idea of being left with a major debt to repay at the end of the mortgage term can be off-putting, and understandably so.
Just as is the case with all financial products, affordability and cost-effectiveness vary on a case-by-case basis.
The difference between the two mortgage types
Roughly summarised, this is what makes the difference between an interest-only mortgage and a repayment mortgage:
- With a repayment mortgage, you gradually repay the full outstanding balance of your mortgage over the agreed-upon term, and at the end of the term, the mortgage is paid off and you own your home.
- With an interest-only mortgage, your monthly repayments only cover the interest. When the repayment period comes to an end, you still owe the lender the full price of your home, i.e., the full outstanding mortgage minus interest.
The latter is considered the most undesirable option; the vast majority of home loans are issued in the form of repayment mortgages. Being left with the full price of your home to be paid when the term reaches completion is a legitimate cause for concern.
This does not necessarily mean that a repayment mortgage cannot be a viable and cost-effective option; it all depends entirely on your financial situation and long-term plans.
Initial vs. long-term savings
A homebuyer takes out a mortgage of £400,000 with a ten-year introductory fixed rate of 2.5% over the course of 25 years. If this loan was issued as a repayment mortgage, they would be paying around £1,795 each month to the lender. With an interest-only mortgage, their monthly payment would be reduced to £834.
The borrower in question would be looking at around an extra £1,000 in their pocket each month, giving them the option to save, invest, or inject cash into their business. At the end of the mortgage term, when the balance of the mortgage is due, they could have accumulated enough cash to cover the debt and pocket a profit in the process.
By contrast, a repayment mortgage would leave the borrower with much less to play with each month but with no final debt to pay 25 years later.
Choosing the right option
Interest-only mortgages are not suitable for everyone. For the sake of simplicity, security, and confidence, most people are better off considering the standard repayment option.
There are instances where borrowers meeting very specific criteria could find interest-only a more economical option.
Consulting with an independent broker before applying is therefore essential in order to ensure you fully understand the options available and which are suitable for your requirements.