Types Of Mortgage

A Mortgage is a sum of money borrowed from a bank or building society in order to purchase a property. The money is then paid back to the Lender over a fixed period of time together with added interest.

There are essentially three different methods to repay a mortgage:

Repayment Mortgage

A repayment mortgage, traditionally known as a capital and interest, is when you pay the capital and interest together in your monthly payment over the term of the mortgage. In the early years your payment consists mainly of interest however over time as the mortgage balance reduces the balance of the payments also changes with more capital being paid off. At the end of the term you are assured your mortgage will be paid off assuming you have maintained your payments.

Repayment mortgages have become popular again as people like the assurance of knowing their mortgages will be paid off at the end of the term. 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.
  • Life assurance cover is not always necessary in taking out this type of mortgage.

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 Mortgage

An interest only mortgage is when you pay only the interest on the mortgage balance in your monthly payment throughout the term of the mortgage. At the end of the term the lender will require you to pay off the outstanding balance, which will not have decreased, from your own funds. Although it is recommended many lenders no longer make it compulsory for the borrower to put some form of investment product in place to accumulate the funds to pay off the balance over the term of the mortgage.

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.

Endowments provide life assurance so that in the event of death the mortgage is paid off.

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 ISA’s 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 minimize 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.

Part and Part Mortgage

A part and part mortgage, sometimes called a split mortgage, is when you have a combination of both repayment and interest only. In recent years many people have converted part of their mortgage to repayment to allow for the anticipated shortfall in their endowment and this has resulted in them having a part and part mortgage.

Use Mortgage Cost Calculator to help you compare the monthly cost of a Repayment and an Interest Only Mortgage.

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