What is the most suitable way of repaying your mortgage?

Picture of a new house

Once you have established what type of mortgage need you have you will want to decide on the most suitable way of repaying your mortgage.

This section will explain the various repayment options. They will not necessarily all be available to you from a particular lender or for the type of mortgage need that you have.

Capital and Interest Mortgage

A capital and interest mortgage is also referred to as a repayment mortgage.  The majority of people seeking a mortgage would find this method of mortgage repayment to be the most suitable.

The name of the scheme refers to the fact that each month you will be paying a mixture of the capital you have borrowed (i.e. the mortgage loan) and the interest that is being charged by the lender. 

In the early years of the mortgage most of your payment will consist of the interest required.  However, as time elapses more of the payment goes to paying off the capital and in the final years nearly all goes to paying off the balance of the loan.   

The monthly payment is calculated taking into account both the payment of the capital and the interest.  The repayment is recalculated every time there is a change in the interest rate. 

The amount of the payment you make each month depends on the size of the loan, the number of years the mortgage is taken out over and, of course, the interest rate that is being charged. 

Some lenders will insist that you take out life cover that will pay off the mortgage in the event of your death.  If not, it is advisable to consider it as a precaution.  This is particularly so if you have dependents who would be unable to pay the mortgage if your income ceased.

This is the method of mortgage repayment that most people should use because:

  • you are sure to repay your mortgage at the end of the term provided, of course, that you keep up the monthly payments. 

  •  as you are repaying part of the capital borrowed you are building up ‘equity’ in the property.  ‘Equity’ is the difference between the selling price of your property and the amount you still owe to the lender.  This equity can easily be carried forward to your next property if, or when, you move again. 

Flexible Mortgage

Flexible mortgages have gained in popularity since borrowers’ circumstances can change much more rapidly and dramatically nowadays than was the case in the past.  Few people can claim to have a job for life, for example, and the divorce rate is higher.

As a result of this growing demand for flexibility in mortgages a number of lenders are now offering mortgages which give you many more options than before. 

These may offer some or all of the following options:

  • paying more than the agreed monthly payment
  • paying less than the agreed monthly payment
  • payments for only ten months of each year
  • making 13 ‘monthly’ payments each year
  • temporarily stopping payments
  • lump sum payments
  • ‘cheque books’ to allow withdrawal of a pre-determined further advance

Offset/Current Account Mortgage

These are repayment mortgages where there is a link to your current account, although some lenders will also link to your deposit account.  Money that you hold in that account is ‘offset’ against your mortgage for the purposes of calculating the interest that is due each month.  The end result can be substantial savings on your monthly mortgage payments.

The combined balance of your outstanding mortgage and the money in your current account is calculated daily.  You then only have to pay interest on the combined balance. The more money you have in your current account, the less interest you pay on your mortgage.

If, as an example, you have £30,000 in your current account and £100,000 left to pay on your mortgage, you would only need to pay interest on £70,000 of your mortgage.

You will usually have a choice of paying the lower mortgage repayment that is produced by ‘offsetting’ your current account balance or paying the same amount so that the difference can go towards paying off your mortgage that much earlier.

This has several advantages if you have the right type of circumstances:

  • you save money on your interest charges or you can elect to pay the same amount and reduce the term of your mortgage as there is no limit to how much you can have in your current account an offset mortgage could allow you to pay off your mortgage years earlier.

  • higher rate tax payers particularly benefit from in effect getting a very much higher net return on money held in their current or deposit account.  Interest is not paid on your current account or any other account that is linked to your mortgage.  However, the effect particularly for higher rate tax payers can be to provide an effective rate on their savings which is far in excess of anything they could otherwise earn from a deposit account.

  • you can consolidate all your borrowing at one low interest rate

  • you can have access to additional funds quickly and easily

The thing that you need to watch with this mortgage repayment method is that because it is very much easier to borrow additional amounts you may find that your borrowing is getting out of control.

Interest Only Mortgage

This is simply where you repay interest only to the lender without arranging to repay a portion of the capital each month (as with a repayment mortgage). 

The full amount of the loan has to be repaid to the lender at the end of the term.  The capital could be repaid by the sale of the property. 

This is a high risk way of dealing with your mortgage because the debt is still all there at the end of the term, all you have done for 25 years or so is pay the interest.

The advantages of this method are that:

  • it costs less to service your mortgage than any other repayment method.

  • you can choose any method you like to repay your mortgage.  You could, for example, choose from a variety of investment vehicles, decide to repay your mortgage from an expected inheritance or the cash sum from your pension.

  • However the amount of debt does not reduce over time and there is no certainty that you will have the necessary cash at the end of the term to repay your mortgage.

Interest only mortgages have been used by large numbers of borrowers in the past in conjunction with low cost endowment plans and marketed as Endowment Mortgages. 

However, a great deal of pain has been caused to both policyholders and the investment community as a result of endowment mortgages.  The dramatic falls in inflation and interest rates removed the advantages of such schemes to the point where most people who were hoping to repay their mortgage using a low cost endowment faced substantial shortfalls on the amount required to do so.

Risk Factors

Your home may be repossessed if you do not keep up monthly repayments on your mortgage.

The Money Advice Service information sheet ‘You can afford your mortgage now, but what if …?’ will help you consider the risks.

You can obtain a free copy from https://moneyadviceservice.apsmos.com/ViewArticle.html?sp=Sengyoucanaffordamortgagenowbutwhatif-136


Links to more information

Important

This information does not constitute personal advice and should not be treated as a substitute for specific advice based on your circumstances.

Information given relating to tax legislation is based on my understanding of legislation and practice currently in force. Whilst I believe my interpretation of current law and practice to be correct in these areas, I cannot be responsible for the effects of any future legislation or any change in interpretation or treatment. In particular you are warned that levels of tax and tax reliefs are subject to alteration and, in any case, the value of such reliefs and benefits may depend on an individual’s circumstances.

If you are in any doubt as to whether any course of action is suitable for you, then you should discuss the matter with a suitably qualified independent financial adviser or other specialist.