Paying the mortgage – Repayment or Interest Only

One of the biggest choices you might have needed to make in the past was a choice between an “interest only” mortgage or a “repayment mortgage”. Interest only mortgages are becoming increasingly difficult to find outside of buy to let mortgages so it is perhaps less of a consideration than in the recent past but it still pays to know the difference. Let’s start with interest only as in some ways that’s the easiest to understand.

Interest Only Mortgages

Let’s imagine that you want to borrow £100,000 and the mortgage interest rate is quoted as 5%.  In an interest only mortgage the amount you pay each month is purely the interest that grows on the debt over the month in question.  So in this example £100,000 would grow by £100,000 * 5% / 12 = £416.67.  Therefore this becomes your monthly repayment amount.  Therefore every month you go through the process of

  • You start every month owing £100,000
  • Over that month your mortgage debt grows from £100,000 to £100,416.67 (i.e. it increases by £416.67).
  • At the end of your month you pay £416.67 off your mortgage returning the amount owed to £100,000
  • Start Aagain….

So in an interest only mortgage the mortgage debt never reduces below the amount borrowed of £100,000. You would still owe this at the end of the mortgage term (i.e. 25 years for example). Therefore if you don’t want to have to sell your house at the end of the term you are going to need some sort of savings pot with which to repay the £100,000. If you want to end the term with nothing left to pay then we are talking repayment mortgages……..

How Repayment Mortgages Work

In contrast to interest only mortgages repayment mortgages work to reduce your outstanding mortgage month by month. Going back to our example above if the mortgage was taken out over a term of 25 years, the repayment at 5% works out to be £584.59 per month. As you can see this is greater than the interest only repayment of £416.67 and so it will work to reduce the mortgage debt over time. An example might help.

  • You start in month 1 owing £100,000
  • Over that month your mortgage debt grows from £100,000 to £100,416.67 (i.e. it increases by £416.67).
  • You make a payment of £584.59, which reduces your mortgage debt to £100,416.67 – £584.59 = £99,832.08
  • You now start month 2, owing £99,832.08
  • Over that month your mortgage debt grows from £99,832.08 to £100,248.05 (i.e. this month it increases by £99,832.08 * 5% / 12 = £415.97) – NB : The interest charge is getting smaller each month because we are paying back the mortgage debt.
  • You make a payment of £584.59, which reduces your mortgage debt to £100,248.05 – £584.59 = £99,663.46
  • and so on, after 25 years the mortgage debt will be 0