Buying a property is one of the biggest financial commitments you will make. When buying a home, you will likely hear about interest-only mortgages and repayment mortgages. The two are very different, and it can be very helpful to understand what each one means and how it might affect your repayment options. The type of mortgage you choose can also determine what type of life insurance you can take to cover the debt.
In this guide, we’ll help you to understand an interest-only mortgage versus a repayment mortgage, including how they work and which type you should choose depending on your circumstances.
What is an interest-only mortgage?
An interest-only mortgage means that your monthly payments only go towards paying off the interest on the mortgage, not the capital. It means that your monthly payments don’t pay off any of the loan you took out to buy the property, and you will need to pay the full amount back at the end of the mortgage term.
Interest-only mortgages were popular before the 2008 crisis, where people could borrow on an interest-only basis. Since 2008, less lenders are willing to offer interest-only mortgages. According to Which, there were 73 lenders willing to lend on an interest-only basis before 2008, and currently there are only 18.
Today it is much more difficult to borrow for an interest-only mortgage, as there is stricter criteria on loan-to-value ratios and salary requirements.
What is a repayment mortgage?
A repayment mortgage differs from an interest-only mortgage in that you repay some of the capital and some of the interest each month. So long as you meet your monthly payments, you will have repaid the loan by the end of the mortgage term, which is usually 25 years.
During the first few years, your monthly payments will typically pay off more of the interest than the capital, but this balance will shift as time goes on.
A repayment mortgage is the most common mortgage, but there are a number of different types to be aware of.
· Fixed-rate mortgage – the interest rate remains fixed for a set period of time
· Standard variable rate mortgage – the interest rate will match your lender’s rate, which they can move when they like
· Tracker mortgage – the interest rate will track a fixed economic indicator, usually the base rate plus a set percentage.
· Discount rate mortgage – this usually offers a discount on a lender’s standard variable rate
Should you choose an interest-only or repayment mortgage?
Interest-only mortgages will typically be less per month than a repayment mortgage, but it’s important to remember that you will still owe the original amount you borrowed. Usually interest-only mortgages are suited to those who have a lot of equity or a repayment plan to pay back the lump sum. For this reason, interest-only mortgages are not recommended for first-time buyers.
There are some instances where an interest-only mortgage may be suited to you. For example, interest-only mortgages are often used for a buy-to-let mortgage. There's also something known as retirement interest-only mortgages available.
Retirement interest-only mortgages are aimed at those who are in, or nearing, retirement. It can help older borrowers who might struggle to get a standard residential mortgage, or those who are nearing the end of an existing interest-only mortgage but are unable to repay the loan.
Whichever type of mortgage you decide on, it’s important that you have the necessary funds to make the monthly payments.
How to protect your mortgage with life insurance
If you were to pass away, mortgage life insurance could be a huge helping hand for your partner or other dependents, as it gives them the financial support to pay off the mortgage. Depending on the type of mortgage you have taken, there are different insurance policies to consider.
Mortgage life insurance, also sometimes known as decreasing term life insurance, will reduce in line with a repayment mortgage. As you continue to pay off more of your mortgage each month, your cover will reduce with it. This means your loved ones will have access to the right amount of financial support for the amount left on the mortgage, if something was to happen to you.
If you have an interest-only mortgage, you should consider level term life insurance as the amount of cover stays the same throughout the term. This means your family will have enough to cover the capital that is due on your mortgage, which does not decrease over time.
Please note that the descriptions above do not constitute as financial advice and may change depending on individual circumstances and budgetary requirements.
If you need more help and advice on choosing the right life insurance policy, get in touch and our advisors will be happy to help.