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There are two types of mortgages. The first and most popular, is the Repayment Mortgage where you pay off the capital (the amount of money loaned) and the interest every month as part of your mortgage payment. The other type is the Interest Only Mortgage where you only pay off the interest on your mortgage every month.

What this means, is that if you take out an Interest only Mortgage, once the term of the loan is over, you will have paid off all the interest, but you must find the capital i.e. the price of the house.

For example, if you bought a house for '100,000 over the course of the next e.g. 25 years, you would have managed to pay off the interest (probably about '150,000), but you will not have paid off any of the '100,000 so the lender will be expecting a payment of '100,000 at the end of the mortgage deal. A lot of money for the vast majority of us.

In order to be able to re-pay the capital on the loan, there are 3 commonly used methods which are usually employed so that the borrower has the funds available to be able to pay off the loan. They are as follows

Endowment
An endowment is an investment scheme which was very common in the 1980s and early 1990s. The idea was to have an endowment and an interest-only mortgage. You would pay a monthly premium to the company (often an insurer) who sells you the endowment, and the policy was supposed to grow over the years. This way, when the policy matures, you would be left with enough money to pay off your mortgage and most people also expected to have a significant lump sum of cash too.

However, what happened is that the performance of the endowment is linked to how well the Stock Market performs so when the Stock Market crashed in the late 1980's, the endowments weren't worth as much as people thought they would be.

In essence, if the borrower took out an endowment mortgage for '100,000, if has had happened in the past, the endowment at the end of the term of the mortgage would have been worth at least '100,000 if not more. Some policies were worth a lot more. Any excess(profits) on the '100,000 would have gone to the borrower. However, what happened is that a lot of endowments after the crash were worth a lot less. This meant that the borrower would have to find the shortfall from somewhere else.

As you can see with the above illustration, this type of mortgage is very risky, offering a potential of a big gain, however, there is always the possibility of problems.

Despite the bad publicity and the inherent problems, it may be that this type of mortgage is suitable for some people and a number of lenders still offer Endowment Mortgages.

ISA (formerly known as Peps)
With this type of mortgage, you're still paying off the interest only, however, you also pay into an ISA. There are a number of different ISA's available, however, the main advantage is that the money you pay in, earns interest free of tax.

A disadvantage though, is that you are only allowed to put a certain amount of money into an ISA every year, so by using an ISA for your mortgage, you are missing out on using the ISA for savings.

Pension
This way of paying off an interest-only mortgage, is by far the least common. Most forms of pension fund let you take 25% of their value as a tax-free lump sum at retirement. The idea behind pension mortgages is that you are paying off the loan not only using a fund which grows free of tax (like an ISA), but you are also effectively getting tax relief on your mortgage contributions as well. The problem is a distinct lack of flexibility, and the fact that you can't pay off the mortgage before retirement.

The other example of using Interest Only Mortgages is with regards to buying homes to rent out. The rental income received is often enough to cover the value of the interest only payment plus a small profit. Hopefully if you've chosen a house wisely (and luckily), then over a period of time (10 ' 20 years), the house will have risen in value so at some point you will decide to cash in and sell the house for greater than you bought it for.

This policy is very very risky. There is no guarantee that the house price will continue to rise. There are no guarantees that you will be able to find tenants or attract the rental income you need. This is also stepping into the realms of business as opposed to simply home buying.

Interest Only Mortgages are suitable for some people, however, they are much more risky than Repayment Mortgages but it is possible that if everything works out right, then a nice profit can be made.