6.1.2 Repaying your mortgage
Another major choice to be made about a mortgage is how to repay it. The options are a ‘repayment’ mortgage or an ‘interest-only’ mortgage (or perhaps a combination of the two).
With a repayment mortgage, the capital or principal sum (the original amount of debt) is paid off in stages throughout the life of the loan. Look at the table below to see the pattern of payments on a repayment mortgage. The typical structure is a reducing balance loan with a set amount paid each month throughout the mortgage term unless the interest rate changes.
The effect of this is that the amount of the principal sum repaid accelerates over the term of the mortgage – initially the majority of annual mortgage costs are made up of interest payments, and then towards the end of the mortgage term these costs are mainly repayments of the principal sum.
One consequence is that a borrower who wishes to repay early might be surprised at how much of the principal sum remains. The table shows a £100,000 repayment mortgage payable over 25 years, at 7% APR with interest calculated monthly. Results will vary slightly if different periods are used – for instance, a daily calculation of interest. Only selected years are shown.
Table 1 Paying off your mortgage – interest and capital
|Year||Interest||Capital||Total repayments for year|
With an interest-only mortgage, the principal sum outstanding is unchanged throughout the life of the loan and only interest payments are made to the lender until the end of the loan period. At the end of the period the borrower must have the means to repay the lender the principal sum. Failure to do this will result in the property being repossessed because it is secured against the debt.
With interest-only mortgages, repayment of the principal is typically achieved by putting money into a savings or an investment scheme (such as an ISA or unit trusts) throughout the life of the mortgage. (In the past, endowment insurance policies were also available to pay off the principal – hence the name ‘endowment mortgage’.)
To determine how much to save each month, the investment is projected to grow at an assumed rate in order to produce a lump sum large enough to repay the principal sum in full on the maturity of the mortgage. Following a reduction in the projection rate in 2000 to reflect changed economic conditions, the market for interest-only mortgages substantially declined, especially for first-time buyers. In October 2010, 93% of first-time buyers took out a repayment mortgage; this compares with 70% before 2007 (BBC, 2010) and just 47% in 1999 (Council of Mortgage Lenders (CML), 2001).
When comparing the interest charges on different mortgage products there are some key points to consider. As you may recall from Week 4, in order to obtain an accurate comparison of the interest charges on different debt products it’s useful to look at the APR quoted. This calculates the cost of the mortgage over its life, taking into account discounts and additional costs (which are not included in the quoted interest rate of the mortgage) as well as the timing of interest payments and charges.
The APR does not include charges for early repayment or options such as insurance or payments into an investment product for an interest-only mortgage. In addition, the APR will not take into account the cost of any mortgage indemnity guarantee (MIG) that might be levied on a higher risk borrower, for example, where the outstanding mortgage is high relative to the value of the property. (The term used to describe the ratio of mortgage to property value is ‘loan-to-value’, or LTV.) Provided the products are comparable (for example, all repayment mortgages), a low APR indicates that a mortgage is cheaper than one with a higher APR.
To help the process of making decisions in such a complex mortgage market, the UK’s financial regulator for this area has stipulated that each mortgage seller must provide a Key Facts Illustration (KFI). This document is produced as part of the mortgage application process, and includes details of the features, terms and conditions of the mortgage product to enable borrowers to compare different products on the same basis.
Included in the KFI is information on the overall cost of the mortgage, the amount of regular repayments, the APR and whether there are any early redemption penalties. The KFI also illustrates by how much monthly mortgage repayments would rise if there were a 1% increase in the rate of interest on a variable rate mortgage.
The introduction of the KFI can be seen as an example of regulators responding to the complexity that accompanies increased competition, in this case by insisting that lenders provide information to enable mortgage customers to compare products more easily.