Mortgage Repayment

A mortgage, including a remortgage, is a form of loan for which your home is provided as security: if you fail to make the payments, the lender can take possession of your home and sell it for enough to get their investment back.

You pay that loan over an agreed period. It is essential, therefore, that you replay your mortgage as agreed.

Mortgages can be taken over any agreed period of time, and although the most common is 25 years, it can vary according your ability to pay: if you want a lower monthly payment you can extend the term and if you can afford to pay more, you can reduce it to 10 or even 5 years. The longer the period of the mortgage, the more interest you will ultimately pay.

The amount you borrow is referred to as the capital, and you will also pay interest as part of your monthly repayment. There are two major ways of arranging your repayments: by means of a repayment mortgage or with an interest-only mortgage.

Repayment Mortgages

With a repayment mortgage you pay a fixed sum each month, comprising a payment towards part of the capital and the interest due for that month.

As your capital reduces, the amount of interest you pay also reduces, so an increasing proportion of your payment is for the capital. The monthly payment is arranged so that the final payment, at the end of the agreed period, pays the last of the capital and the small amount of interest due for the final month.

In some cases interest is calculated daily, and in others the interest you pay for any month is calculated on the sum owing at the beginning of that month. You would be well advised to negotiate a daily interest mortgage since your interest payments would be lower. One disadvantage of a repayment mortgage is that you are paying mainly interest in the early years, so if you sell your home just a few years after mortgaging it you will find that you will owe almost as much as you borrowed. That puts many people off selling until the mortgage is well advanced.

Some lenders will offer you the flexibility to pay extra when you can afford it, and to miss a month when you have difficulty. This is without a doubt the safest and securest way of repaying a mortgage, whether the original loan or a remortgage, because your property is paid for at the end of it, and you are repaying in straight installments. However, there is an alternative if you have reason to believe that you will have enough money to pay off the loan after a period of time: the interest only mortgage.

Interest only mortgages

With interest only mortgages, your monthly repayment is only for the interest. You pay back none of the capital at all.

If this sounds a bit illogical it is not if you know you will be able to pay the loan at the end of the 25 years, say. In fact, if interest rates rise at a lower rate than inflation, you could benefit considerably. However, the opposite could also be true.

A good way to arrange this would be to make payments into an investment fund, personal equity plan or individual savings account that pays a good rate of interest. If your investment or savings grow as you expect them to, you should not only be able to pay off your home, but also have a good sum left over.

Suitable plans include index trackers, and an ISA can be used to keep your tax down. However, interest only loans are not for everybody. For a start, there is no guarantee that interest rates will not drop, as they have recently with the Bank of England, and in so doing ruin your projected investment growth. It is acceptable if you increase your investment amount each month, but if not there is a grave danger of you not having enough money at the end of the period to pay off your home. If that is the case, you will likely lose it, unless you have sufficient equity through increased house prices to be able to raise the sum on a second mortgage. That itself is very doubtful during a period when interest rates are falling.

You also have to consider the possibility of interest rate increases that could compromise your ability to pay the corresponding increased interest payments. If you start of close to your affordable limit, it doesn’t take mush to significantly increase your interest commitment. It is an unfortunate fact that any interest rate fluctuation can damage your ability to pay: a rise by demanding increased monthly interest payments, and a fall by demanding increased monthly payments to cover the investment shortfall in growth.

This type of mortgage is popular with people who are buying to develop and sell at a profit, and are mortgaging over a short period of time. They can pay off the mortgage in a lump sum from the proceeds of the sale. Here are some of the dangers of interest only mortgages in more detail.

Dangers of Interest Only Mortgages

There has been an increasing trend for people to take interest only mortgages and then fail to save sufficiently to pay the capital at the end of the term.

In fact, there has been a worrying trend for some people to save nothing at all, with the intention of downsizing and selling the house at the end, relying on the natural rise in property prices to provide the money to clear the debt and provide sufficient extra to purchase a smaller home.

Such a plan is ill advised, and can very easily lead to repossession and even to bankruptcy. Interest only mortgages have to be monitored regularly, to make sure that the money available will be sufficient to clear it. If anything unplanned happens, such as a drop in the value of your investments or a reduction in interest rates negatively affecting the growth of your savings, you have to take immediate action to counter it.

For example, a reduction in interest paid on savings and investments is normally associated with a reduction in the interest charged on mortgages. That means that you would be paying less each month: don’t reduce your payments but direct the extra into your savings, or even better, increase your monthly savings. If you aren’t sufficient flexible financially to do this, then perhaps you shouldn’t be thinking about this type of mortgage.

25 years seems a long way away, and it is very tempting to take an interest only mortgage because of its lower payments, but you are only putting misery into the bank, and once you are 20 years older you might be dreading the end of the mortgage period; for a full five years you will worry every morning you wake up. Is it worth it?

Of course it isn’t, so if you take this type of mortgage make sure you are paying all you can into your investment or savings account. You can always reduce it once you are ahead, but it will be difficult to catch up if you get behind. Many promise to start saving ‘next year’, but next year never comes. To avoid this, some opt for an endowment mortgage.

Endowment Mortgage

This is a form of interest only mortgage. You basically make two payments: one for the monthly interest and the other into an endowment insurance policy. The endowment is a combination of life insurance, investment and savings all in one single policy.

The life insurance portion covers the loan so that it is paid off on your death. The investment and savings portion is designed to pay off the house at the end of the mortgage period and to provide you with a bit extra. Nothing is paid from the capital, only the interest, until the endowment policy matures at the end of the 25 years or the period for which the mortgage was arranged. This type of mortgage, therefore, is just the same as an interest only mortgage; only you have to pay the investment and savings from the first month, and can’t miss a payment if you feel like it.

The dangers of interest only agreements therefore apply equally to endowment mortgages, and the latter have been steadily reducing in popularity with both borrowers and lenders. This is because of the general downturn in inflation over the years, and a reduction in the growth of such investments. Interest rates are no longer as high as they once were, and the value of savings has been growing at a much slower rate over the past two decades. Many endowments fell short of the amount needed to pay the loan, and many people lost their homes or had to take loans to pay the shortfall.

Although it would have been possible to pay more into the endowment fund, as is possible with straight interest only mortgages, the potential of a shortfall was not communicated to borrowers, the majority of whom are not familiar with the concept behind endowment mortgages. Not only was there a lack of communication, but many mortgagees had their mortgages mis-sold to them in that they were informed that the endowment was guaranteed to cover the mortgage, which is not the case.

That is why we do not offer endowment mortgages here: they are over-expensive, too flexible and underperforming, and very few mortgage lenders now offer them as an option.