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May 21, 2020

Capital Repayment v. Interest Only Mortgages: Huh? What’s the difference?

If you need to know more about the basics of different types of mortgages ready our handy guide to understand more.

Having just been through a pretty stressful application process, I wanted to expand on the different types of buy to let mortgages that are available.

Committing to a mortgage is not a decision to be taken lightly, and seeking help from a qualified professional is vital.

What I have shared below isn’t meant as advice. It is geared towards helping you differentiate what options are out there and help give you a better understanding of what may be right for you.

With that out the way, let’s get started.

Capital & Interest repayment and interest-only are the two main two types of mortgages used to purchase a property, and regardless of which one you select, there will be similarities. Things such as the term of the loan, do they follow a tracker, or offer a fixed interest rate over a set period will apply to both.

So, what’s the difference?

A capital repayment mortgage means you pay the interest and a portion of the loan each month. That means by the end of the mortgage term, typically 25 years, you will have repaid the entire debt, and you own the property.

With an interest-only mortgage, you only pay interest, and none of the money borrowed, which means you won’t own the property at the end of the mortgage. Therefore, if you wish to keep the asset, you need to be able to repay the entire balance at the end of the loan term.

You can do that through vehicles such as a savings account, a pension fund, or, by other means such as inheritance. Alternatively, you could sell the property. However, that would result in losing the income you have been receiving.

Capital Repayment:

These mortgages are pretty straight forward. You pay both the capital and the interest of the loan. The overall amount of interest you pay is lower than interest-only because your debt decreases every month. With a capital repayment mortgage, a portion of repayments is associated with clearing the debt, and you are usually able to get lower interest rates throughout the mortgage term as your outstanding balance reduces. However, the monthly repayments are higher than with an interest-only mortgage.

Interest-Only Mortgages:

As mentioned above, with an interest-only mortgage, you only pay the interest each month which means you still have to cover the debt at the end of the loan. There are a few pros and cons to this approach.

The Pros

  • Lower monthly payments
  • Inflation erodes the debt over the life of the mortgage
  • You can purchase more expensive properties by qualifying for larger loans
  • You can free up money to put into alternative investments helping you diversify and build your net worth
  • Offers the ability to save money that could help pay off the mortgage faster

 The Cons

  • It can be more expensive as what you have to pay over the loan term doesn’t decrease. Unless you remortgage at a lower interest rate
  • If there is a severe economic downturn you may be financially exposed
  • You need to have the funds to repay the debt at the end of the term or risk losing the property
  • If you are using an alternative investment to repay the debt, you carry the additional risk of that asset

Selecting Which is Best for You

Again, when selecting a mortgage, you must deal with a qualified professional who understands your situation. A regulated broker will be able to guide you to the best options in the market, as it depends on individual circumstances. A capital repayment can be a good option if you are debt adverse and want an asset that you own outright at the end of the mortgage term, and it is not a bad choice by any means.

Personally, I (and most investors) prefer interest-only as it offers a lot more flexibility. Also, if you look at UK property growth over any 25 year period in history, it has always risen inline or above inflation, and the market generally goes in an upward trajectory. As long as you are responsible with the amount of leverage you use, you should be ok.

Could that change? Sure, I suppose it could. However, given the way our economy is structured, I find that pretty unlikely.

Also, the fact that inflation erodes the debt over the life of the mortgage is a big plus point of interest-only mortgages. One thing is for sure, 100k today will be worth a lot less than 100k in 25-years as inflation rises.

That is why keeping large portions of money sitting in a bank account getting zero interest is a terrible idea.

Example

Check out this inflation calculator, £100,000 in 1995 had the purchasing power of £200,677 in 2018.

That means if you bought a property for £100,000 with a 75% mortgage, you would still only owe £75,000, yet the property would be worth £200,667. Pretty mind-blowing!

If you would like to learn more about how to use financial leverage responsibly and to your advantage,
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Article by: Rory van den Berg