Interest-only vs repayment mortgages: buy-to-let guide
When people buy a house they intend to live in, they usually take out a repayment mortgage, which means that pay off a small amount of the debt they owe each month until the loan is paid off in its entirety and they own the property outright.
While some buy-to-let landlords do take this route too, many opt for interest-only mortgages instead. With this type of loan, you only pay off interest each month rather than paying back any of the capital you borrowed. You then have to pay off the entire loan at the end of its term.
While this can be advantageous to landlords in that it lowers the cost of monthly mortgage payments, there are some disadvantages to this approach too.
If you’re weighing up the pros and cons of an interest-only vs. repayment mortgage for your buy-to-let property, read on for our landlords’ guide to these two types of repayment schedule.
What is a repayment mortgage?
A repayment mortgage is the traditional type of mortgage taken out by the majority of residential buyers. Buyers borrow a fixed amount of money towards the purchase of a property and then pay off a small portion of this each month over a fixed period of time until the loan has been fully repaid. They also have to pay interest on the amount they borrowed, which is calculated at a value of the outstanding amount owed. Mortgage rates vary according to the lender and the specific financial products they offer, as well as your personal financial situation.
In the first few years after taking out a repayment mortgage, most of the payments you make go towards paying off the interest on the loan. But as you pay off more capital, the interest you pay decreases, as it’s calculated as a percentage of the outstanding balance of the loan. This means that, although you might pay the same amount each month, you will be paying off more of your loan with each payment as the years go on.
Some lenders will also allow holders of repayment mortgages to overpay (within certain limits), which can save you money on the interest over the life of the loan. At the end of the mortgage’s term, you’ll own the property outright.
What is an interest-only mortgage?
With an interest-only mortgage, you only pay off interest each month and don’t pay anything towards the actual capital you borrowed. This type of mortgage is understandably more popular with buy-to-let landlords, who might be more inclined to see property as an investment.
If you opt for an interest-only mortgage, your monthly payments will be lower, which can be a big advantage for landlords. However, you do of course have to pay back the capital owed at the end of the term.
Pros and cons of repayment and interest-only mortgages
The biggest advantage of taking out an interest-only mortgage is that your monthly mortgage payments will be lower. This means you could use the extra money saved to expand or improve your portfolio, instead of paying off the mortgage.
However, not all lenders are prepared to offer mortgages on an interest-only basis, and some of those that do will only let you do this for part of the amount you’re borrowing. Since these mortgages are considered as higher risk for the lender, they often require you to pay a larger lump sum as a deposit too.
Of course, you’ll also have to pay off the balance at the end of the term, and lenders will want to know how you intend to do this. This might mean providing proof of endowment policies, investments or other properties you intend to sell to repay the loan.
Many landlords buy properties with a view to selling them again later — hopefully at a profit. If you can do this, you can easily pay off the balance of the loan using the proceeds from the sale. However, there is a risk involved too: if the value of the property decreases, you’ll still need to pay back the amount you borrowed and could end up out of pocket.
Repayment mortgages are more straightforward. Although your monthly payments will be higher with a repayment mortgage, each one goes towards paying off the balance you owe to the lender, and at the end of the term, you will own the property outright.
With a repayment mortgage, your interest also goes down over time, as the sum you owe decreases. We’ll go into this in more detail below.
How much does each type of mortgage cost?
Though you pay less each month with an interest-only mortgage, you will end up paying more over the term of the loan, because the amount of capital doesn’t decrease. In the examples below, we’ll assume that the mortgages described are fixed-rate mortgages (the interest rate doesn’t change over time), with a loan term of 25 years.
Let’s say you want to buy a home for £220,000 and have a deposit of £20,000 available. This means you need to borrow £200,000. If a lender offers you a 25-year mortgage at a 3% interest rate, you need to pay 3% of the sum you owe in equal monthly instalments each year. This means you would need to pay £500 every month for the 25 years of the mortgage.
In total, you would end up paying £150,000 in interest over the course of the loan, plus the £200,000 you initially borrowed, giving a total of £350,000.
If you took out a repayment mortgage for the same amount and term and at the same interest rate, each monthly mortgage payment would be £948 — almost double the payment on an interest-only mortgage. However, the total interest paid over the 25 years would be less, as it decreases as you begin to pay off the loan.
In this case, you would still pay off the £200,000 you borrowed over the 25 years, but the interest you paid would only add up to £84,478. The total you’ll pay over the course of the loan adds up to £284,478.
Deciding which type of mortgage is right for you
Whether you choose to take out an interest-only or repayment mortgage will depend on your personal circumstances, including the size of your portfolio and what you plan to do with the property in the future.
Landlords with only one or two properties might be better off taking out a repayment mortgage so that the income they receive from rent can go towards paying it off. However, if you want to expand your portfolio quickly, the lower monthly payments on an interest-only mortgage might allow you to invest in your portfolio and ultimately increase its value.
Interest-only mortgages are also potentially a good option for those with large portfolios, or who plan to sell their property at a later date (and there’s a reasonable chance that it will at least retain its value, if not turn a profit).
Calculating how much you’ll end up paying with each type of mortgage can be difficult, but thankfully there are free mortgage calculators available to help you, such as this free one from MoneySavingExpert.
Can you switch from one type of mortgage to another?
It’s sometimes possible to switch from an interest-only to a repayment mortgage or vice versa, but this depends on your mortgage provider — not all lenders will alow you to do this. If you want to switch from an interest-only to a repayment mortgage, the lender will likely want to look into your financials to check that you can afford the increased monthly payments. Likewise, if you want to move from a repayment mortgage to an interest-only one, the mortgage provider will probably ask how you intend to repay the balance at the end of the mortgage’s term.
If you need help finding the right financial products, head to our free-to-use Finance Hub, where you can explore dozens of products curated specifically for buy-to-let landlords — just fill out a quick questionnaire to get started.
Article by Annie Caley-Renn
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