Repayment
Your monthly repayments consist of repaying the capital amount borrowed together with accrued interest. On your mortgage statement, normally received annually, you will see that the outstanding balance decreases throughout the term.
Advantages of a repayment mortgage
At the end of the term, you are safe in the knowledge that the total amount of the debt has been repaid.
Overpayments and lump sum payments into your mortgage account can be made, reducing both the interest and capital amounts repayable.
Disadvantages of a repayment mortgage
There may be financial penalties for making lump sum/overpayments into your mortgage account. In the early years of a repayment mortgage the majority of the monthly repayment is interest rather than capital. For borrowers moving house regularly, this can result in little of the capital being paid off.
If you have no life assurance cover in place and die before the loan is repaid, the mortgage will still need to be repaid. This may result in the property having to be sold to repay the debt owed.
Interest only
With this type of mortgage, each mortgage payment is only used to pay off interest. At the same time, the borrower takes out an alternative ‘repayment vehicle’ (method of paying off the mortgage) such as an ISA, pension plan or endowment policy. More information on endowments (which in the 1980’s and 1990’s were extremely popular), ISAs and Pension plans is set out below. The most important fact about an interest only mortgage is that the monthly repayments do not repay any of the outstanding capital balance. As a consequence it is important that the payments are maintained into the repayment vehicle; otherwise it will not be possible to pay off the mortgage at the end of the term.
Endowment
This is the most common type of interest only mortgage which also provides life assurance cover and a fixed payment for investment. The fixed payments are based on the amount of the loan together with the mortgage term and are designed so that, at maturity, the amount invested and earnings are sufficient to pay off the mortgage. Much maligned in the press because of the poorer investment growth rates achieved in a low inflationary environment, this form of investment is less popular these days. Note there is no guarantee that, when the endowment matures and ‘pays out’, the balance will be sufficient to repay the mortgage.
Nonetheless millions of borrowers have one or more endowment policies and as a rule of thumb, these should not be cashed-in early and certainly not before seeking advice from a suitably qualified financial adviser. Customers cashing-in an endowment policy in the first few years after inception can receive less than the amount invested. Existing endowments can be used to support a new mortgage with any additional lending over the value of the projected maturity balance being covered on a repayment basis or with an alternative repayment vehicle e.g. an ISA.
ISA
The Individual Savings Account (ISA) is a tax free method of saving. Using an ISA as a repayment vehicle is growing in popularity but due to the ISAs complexity it is only for the financially sophisticated or borrowers taking advice from a suitably qualified financial adviser.
Pension Plan
Life assurance cover is provided and monthly payments are made into a pension fund. When the benefits are eventually taken, the mortgage is repaid using tax-free cash from the remainder of the fund. The plan holder can then draw a pension from the balance of the fund. This product, which tends to be used by the self employed, is only for those taking advice from a suitably qualified financial adviser.
Advantages of an interest only mortgage
If the proceeds of the plans exceed the amount required to repay the mortgage, then this is received as a cash lump sum by the borrower.
Some plans are tax-efficient.
Disadvantages of an interest only mortgage
If the proceeds of the repayment vehicle do not achieve the amount expected, then there will be a shortfall. The borrower remains liable for any shortfall on the mortgage hence the outstanding balance will need to be paid off from other resources. Regular checking of the policy fund itself by the borrower and the lender should minimise any risk. If the plan is not reaching its expected target, the borrower can increase payments into the policy or invest in another product to cover any anticipated shortfall.
Cashing in the plans early may result in financial penalties. These will be provided for in the initial agreement. In addition the lender has no way of tracking some of the more modern repayment vehicles, such as an ISA, which will result in some instances where a borrower lets an investment lapse forgetting or not realizing it is to be used to pay off the mortgage. This will result in situations where there is no method of paying off the mortgage and the lender will only become aware at the end of the mortgage term.
INTEREST RATES ON MORTGAGES
When you have chosen the right mortgage for you, whether it be a repayment or an interest only mortgage, you will need to consider the 5 main mortgage rate options available.
Fixed Rate Mortgage
With a fixed rate mortgage the amount you repay the lender each month can be at a fixed interest rate for a specified period of time, regardless of changes to interest rate in the market place. It is common for lenders to offer rates fixed for a period of 2 to 5 years, but shorter and longer periods can be found in the market. At the end of the fixed rate (or benefit) period the rate will normally convert to the lenders Standard Variable Rate (SVR).
It is normal for lenders to charge up-front fees in the form of booking and/or arrangement fees. In addition lenders frequently apply an Early Repayment Charge (ERC) for fixed rate mortgages. This acts as a lock-in making an often heavy charge for borrowers paying off their mortgage early. Watch out, as the ERC can sometimes last longer than the fixed rate period e.g. a 3 year fixed rate with a 5 year ERC.
Capped Rate Mortgage
A capped rate mortgage is very similar to a fixed rate mortgage except that if the variable rate drops below the capped rate, the borrower will make payments based on the lower variable rate. However, should rates increase the payments will be capped and will not rise over the capped rate. So as a rough rule of thumb a capped rate is better to have than a fixed rate if all other factors are equal. Again, as with fixed rates, up-front charges and lock-ins are common.
Discounted Rate Mortgage
The Lender offers a discount on the Standard Variable Rate (SVR) for a specific period of time. For example, the variable rate may be 5% with a discount of 1.5%. The initial pay rate would therefore be 3.5%. If the variable rate rose to say, 6%, then the rate payable would rise to 4.5%. As the discount is linked to the standard variable rate, the borrower’s payments will increase, if rates rise – so there is no certainty in budgeting. However, should rates decrease, the borrower will benefit from lower payments.
It is still possible to have up-front charges for discounted products and an Early Repayment Charge is common.
With discount mortgages borrowers need to watch out for ‘payment shock’. Some short term discount products offer a ‘deep discount’ e.g. 4% off for 1 year. In such circumstances the borrower will be facing a significant increase in their monthly mortgage payment at the end of the discount benefit period.
Variable Rate Mortgage
Borrowers paying the Standard Variable Rate will have their payments increase or decrease as the lender adjusts the rate in accordance with market conditions.
Tracker Rate Mortgage
This is a variable rate that is linked to the movement of a prevailing rate such as The Bank of England Base Rate or London Interbank Offered Rate (LIBOR). The pay rate will be a set percentage amount above the relevant base rate for a specified period of time. For example if the tracker mortgage is set at 1% above The Bank of England Base Rate for 5 years and the base rate is currently 4.75%, the pay rate will work out at 5.75%.
As their name suggests the rates of tracker mortgages change to follow ‘track’ changes in the base rate to which they are linked. So if the base rate increases by 1%, the pay rate will increase accordingly. Also if the base rate is reduced, borrowers will benefit from a lower pay rate.
Features And Other Benefits Offered With Mortgages
Flexible / Lifestyle Mortgages
A Flexible or lifestyle mortgage is designed to let you make extra repayments when you have extra money, and to reduce or even skip payments when necessary. Borrowers will normally have to build up a reserve through overpayments before being allowed to underpay or skip payments. The main benefit of flexible mortgages is that many schemes are offered on a Daily or Monthly Interest Calculation basis (sometimes referred to as daily rest or monthly rest). Until the arrival of flexible mortgages most, if not all, UK lenders were charging interest on an annual basis. This meant that borrowers making over-payments were not getting the benefit straight away because it could be a year before the capital was reduced by the over-payment. Whereas, on a mortgage where the interest is being calculated on a daily basis, any over-payment reduces the mortgage balance immediately, hence the borrower will be charged less interest from the next day. Without going into detail to explain this feature the up-shot is that over-paying the mortgage on a monthly or regular basis, even by a relatively small amount, will reduce your mortgage term by years (hence saving payments).
Many flexible mortgages come without any Early Repayment Charge so the borrower is not ‘locked-in’ to any particular lender. In addition the interest rate charged is often lower than the usual Standard Variable Rates charged by the other more traditional mortgage lenders.
Offsetting
A flexible mortgage linked to a current and/or savings account held with the lender. These are sometimes referred to as Current Account Mortgages (CAM). These mortgages take the benefits of the flexible mortgage and use the funds held in the current and/or savings account to offset the interest e.g. on a particular day a borrower has a mortgage balance of £50,000 and has £2,000 held in their current and/or savings account. The customer is charged mortgage interest on £48,000 i.e. the mortgage balance minus the positive balance held in the current and/or savings account.
Borrowers should note that when using the money held in their current and/or savings account to offset their mortgage, they will not receive interest on the credit balance held in the accounts.
Cashback
The Lender, as an incentive, will offer a lump sum of cash once the mortgage has been taken out. The amount will vary from lender to lender and on the size of the mortgage. The amounts can range from a flat fee e.g. £200, to a percentage of the loan e.g. 3% of the loan.
Normally the cashback is offered as a package of benefits e.g. linked with a discount, but pure cashback products are not uncommon. Mortgages offering a 5% or even 6% cashback can be found which would mean a borrower taking a £70,000 mortgage would receive £4,200 on completion (at 6%).
Free Valuation or Refund of Valuation
A free valuation requires no up-front payment from the mortgage applicant whereas a refund of valuation will only be made when and if the mortgage application completes. Hence an applicant paying for a valuation and then not proceeding due to, say, a poor valuation will not have their valuation fee refunded.
Moneysupermarket.com as at 8.1.10
