Interest Only or Capital Repayment Mortgage?


Getting a mortgage is a big decision and one
of the biggest financial instruments you will ever take on. There are lots of different
types of mortgage but today we are going to look at one element; should you go interest
only or capital repayment? First, let’s examine each in turn.
In this example we are buying a house for £100,000 – a nice round number that will
help without our calculations. For a standard mortgage, you will normally
need to put down a 10% deposit – in this case, £10,000. We will cover buy-to-let a
bit later. This means we need to borrow £90,000 as a
mortgage. This gives us a loan-to-value of… 90%.
So we have our house, we have our mortgage and the difference between the two (10% here)
is called our equity. Right, now let’s see what happens over time.
It is generally accepted that house prices will rise over the long term, so here you
can see the value of our property increasing over 25 years. Now let’s look at a repayment mortgage.
We have borrowed £90,000 from the bank and we have to pay interest on this, every month.
Let’s assume an interest rate (or APR) of 3% – this works out at £225 per month. We
are also paying back some of the £90,000 each month so that we have paid it all back
at the end of the 25 years. We won’t cover this calculation here but
there are plenty of websites that do it for you. Suffice to say, the repayment amount
is another £205 which brings our total to £430 per month.
So every month, we pay £430 pounds and the value of our mortgage decreases. This makes
our graph look like this. As you can see, our equity increases significantly
over time. At the end of 25 years our home has gone up in value and we no longer have
a loan. This sounds great but there are some things
to think about: Interest rates could go up and increase your
monthly payment. You might move to a bigger house and increase
the size of your mortgage. You might re-mortgage to free up some cash
and thus also increase the size of your mortgage. At the end of 25 years, the equity in your
home is only useful if you take out a new mortgage (thus taking on more debt) or sell
your house. This is why I don’t really consider your
home to be an asset. Yes, it’s worth something, but the money is locked up, and you can’t really get at it. There is a great culture, especially in the
UK, of being a homeowner. This is tied to the crazy myth of working for 40 years to
enjoy retirement on your pension. People strive to own their own home because it is perceived
as a great thing to do. And yes, once you’ve paid off that mortgage you can live there
for free. But economically, it’s not necessarily the soundest strategy. Ok, let’s see what an interest-only mortgage
might look like. In this scenario, the interest we have to
pay – £225 per month – is the same. However, we are no longer paying the extra £205 per
month to repay the mortgage. Over 25 years, it looks like this. At first glance, we appear
to be in a sticky situation because our equity is not as good and we still have a big loan
to pay back. This is the scenario people often fear when choosing what mortgage to go with.
But, consider this: Your monthly payments are almost half as much.
This is a great way to get on the property ladder if you can’t afford a repayment mortgage.
It also mean you have an extra £205 per month to invest every single month. Even if you
put this in a savings account at 5% interest, over 25 years, this would amount to £122,000!
Which is enough to pay back the mortgage with £32,000 spare.
Or you could invest in other assets which would help to further increase your income.
Alternatively, you could just take out another mortgage to extend the term. Your LTV will
be much better due to the increased equity and you still have plenty of equity in your
home to cover repaying the mortgage in the worst-case scenario. So which should you choose? Well It depends
on your strategy. Both options have their pros and cons. If you want to be traditional
homeowner or you don’t care about investing, then get a repayment mortgage. If you want
more cash and want to build a passive income stream, it may be better to go with interest-only.
However, if you will find it hard to be disciplined with investing you could always get a repayment
loan and then re-mortgage in a few years to release some capital.
Now with buy-to-let mortgages, it’s generally preferable to go with interest-only. We’ll
cover this a bit more in the future. If you have any questions, please leave them
in comments section below and let us know your preferred strategy.
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Paul Whisler

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