When taking out a loan, we know that we will need to pay back the money borrowed (the capital) as well as some interest. Adverts for loans and mortgages often include terms like interest only and capital repayment. What do these terms mean? How is a loan advertised as interest only when we know that we must pay back the capital as well?
In this blog we explain the difference between interest only and capital repayment mortgages, explain how they work, and tell you the main reasons for having one or the other.
How do interest only loans work?
When you take out an interest only loan, the capital and the interest are treated separately. You do not pay back the capital until the end of the term. During the term of the loan, you only make payments (usually monthly) that cover the interest.
Let’s take an example. If you borrowed £1,000 for a year, with an annual interest rate of 18%. Each month, you would have to pay interest on the £1,000. The interest rate each month would be 1.5% (18% / 12 month). This means that each month you would pay £15 in interest. In the 12th month you would also have to make a payment of £1000 to pay off the capital.
Our payment schedule would be:
In total you would have paid £1,180 pounds (£1,000 for the capital and £180 in interest)
How do capital repayments work?
In a capital repayment loan, you still make monthly payments, but this time the payment covers the interest and part of the loan. At the end of the term, you have fully paid off the loan. This is called an amortised loan.
After each month you have paid off some of the capital and so the interest in the next month is reduced.
There are two ways you could pay off this loan: reducing payments or static payments.
Reducing payments
In this situation you divide the loan value by the number of payments to get a monthly loan value. Each month you pay the monthly loan value and the interest from that month.
Taking our example above, the monthly loan value would be£83.33 (£1,000 / 12 months). At the end of the 1st month you would pay £15 in interest (£1,000 * 1.5% monthly interest rate) and the £83 monthly loan value; giving a total repayment of £98.33. The outstanding balance of your loan would be £ 917 (£1,000 loan – £83 monthly loan value repaid).
In the second month you would still pay £83 for the monthly loan value but your interest would now be £13.75 (£917 outstanding loan balance* 1.5% monthly interest rate). This graph shows how much we would repay each month.
As the outstanding balance reduces each month, the interest reduces and your payments reduce. In total you would have paid £1,098 pounds(£1,000 for the capital and £98 in interest).
These are not very common as most people find it easier to budget if they make the same payment each month. Most repayment loans use static payments.
Static Payments
With static payments you pay the same each month. Part of your payment covers the interest and the remaining amount reduces the outstanding balance of the loan.
With our example above, your monthly payments would be£91.68. The next graph shows how your repayment is split each month between interest and capital repayment.
In total you would have paid £1,100 pounds (£1,000 for the capital and £100 in interest). The static payment loan is slightly more expensive (£2 over the life of the loan) than the reducing payments version. But most people prefer this type of loan as it is easier to budget a static amount.
Is it better to have an interest only or capital repayment loan?
Unfortunately, like most big decisions there is no single right answer. The answer to the question depends on your situation.
Capital repayment loans are cheaper. As you pay down the loan value each month, the interest reduces. In our example the static payment loan was £70 cheaper than the interest only loan.
The capital repayment loan also gives you certainty that the loan will be paid off at the end of the term. Whereas with the interest only loan you need to ensure you have money available to pay off the loan.
Capital repayment loans also reduce the risk of negative equity.
But there are reasons why some people use an interest only loan:
· If you are buying a house to renovate and sell, the cheaper payments of the interest only loan help with cashflow. You also know that when you sell the house, you can afford to pay back the loan.
· If you were taking out a loan to set up a new business, you might not be able to afford the capital repayments in the first year.
· Some people think that they can invest their money and make a return that would pay off the loan. They make the interest payments each month and put the rest of the money into an investment fund. At the end of the term, they cash in their investments and pay off the loan. This is very dangerous and has led to lots of people getting into financial trouble. You should always speak to a financial advisor if you are thinking about doing this.
· If you want to get on the housing ladder but can’t afford the mortgage payments an interest only mortgage might help. People sometimes do this if they think house prices are going up and so want to get on the ladder now. In the future they then switch the mortgage to a capital repayment mortgage. This is risky as it can increase the risk of negative equity and requires you being able to afford higher payments in the future. Some people set out to do this and can never afford the switch. At some point in the future, they may have to sell their house to pay the loan back.
