Repayment or interest only?

The key decision you have to make is between a repayment or interest only mortgage - you are either paying only the interest on the money you have borrowed, or both the interest and a portion of the capital.

With a repayment mortgage your monthly repayments cover both capital and interest on the loan. No other repayment vehicle is needed, but your lender may insist on life insurance in case you die before the mortgage is cleared.

On the plus side, a repayment mortgage is simple, straightforward and easy to understand. It also avoids the risk of investing in the stock market for your repayment vehicle.

However, unlike a pension, ISA or endowment mortgage, repayment loans do not give you the opportunity to benefit from a rising stock market. Also, when remortgaging, people often choose another 25 year repayment mortgage, to keep the initial monthly costs down. This means that the overall total period of your mortgage debts combined increases over time.

With an interest only mortgage, your monthly payments to the lender cover only the interest on the loan (i.e., they don't repay any of the capital). The full amount of the loan has to be repaid to the lender at the end of the term.

To ensure you can make this final payment, you invest additional funds in investments which are designed to generate enough (preferably more than enough) capital to repay the loan at the end of the term.

On the plus side, you can choose from a variety of investment vehicles, some of which can have tax advantages. And should you move or remortgage, your investment vehicle can usually be reallocated to the new mortgage.

However, unlike a repayment mortgage, the total amount of your debt does not reduce over time. And there is no guarantee that your chosen investment vehicle will grow sufficiently to repay your loan (although you can usually top up your contributions to investments as you go along if this looks likely to be the case).

Charcol is not authorised to offer investment advice.  We recommend you seek professional advice with regard to these topics if you believe they may affect you.