Topic 20 - Mortgage repayment methods (unit 6) Flashcards
What is a repayment mortgage made up as?
A capital element, which repays the outstanding capital over the term of the mortgage;
An interest element, which represents the interest charged on the outstanding capital
Although there are many mortgage products available, there are only two mortgage repayment methods: What are they?
capital repayment (or capital and interest) and interest‑only.
It is important not to confuse mortgage products, such as fixed‑rate and discounted, with repayment methods
What is a capital repayment mortgage also known as
repayment mortgage
If someone has a repayment mortgage what does this mean?
Their repayments include a capital element and an interest element
Why do some borrowers initially feel like they will not be able to repay their mortgage loan in full?
For repayment mortgages it takes several years before there is any noticeable reduction in the amount of capital owed because initially much of the borrower’s monthly payment is allocated to repaying the interest due
How do capital repayment mortgages actually work? ie how are the monthly payments calculated etc
At the start of the mortgage, the lender calculates how
much will need to be paid each month to repay the capital by the end of the term and pay the monthly interest due.
The lender then assumes that the payment will remain the same throughout the term.
At the beginning of the mortgage term, the monthly payment consists largely of interest. This means that the repayment of capital is slow in the early years.
As the term progresses, the balance begins to change, and more of each monthly payment is used to repay the capital, because a lower capital balance means less interest is charged each month
For understanding. This is an example of 2 repayment mortgages showing how a higher interest rate results in a smaller amount of capital being repaid during the early part of the mortgage term
The monthly payment on a new capital repayment loan of £60,000, spread over 25 years, at an interest rate of 5 per cent is £354.78.
This is taken from standard repayment tables available online.
Assuming that the interest rate remains unchanged for the whole of the first year, the amount of interest payable in that year is:
60,000 ÷ 100 x 5 = £3,000
The interest element of each monthly payment in the first year is therefore: 3,000 ÷ 12 = £250
The amount of capital repaid in the first year is therefore:
(£354.78 – £250.00) x 12 = £1,257.36
If the interest rate were 10 per cent, the monthly payment on £60,000 over 25 years would be £550.86.
The amount of interest payable in the first year is:
60,000 ÷ 100 x 10 = £6,000
The interest element of each monthly payment in the first year is:
6,000 ÷ 12 = £500
The amount of capital repaid in the first year is therefore:
(£550.86 – £500) x 12 = £610.32
The examples illustrate that the higher the interest rate charged, the smaller the amount of capital that is repaid during the early part of the mortgage term
An example for undnerstanding
CASE STUDY
John has a repayment mortgage with a term of 19 years remaining. His lender’s rate decreases by 0.5 per cent, reducing John’s required payment by £42 a month. John decides to maintain his existing payments, which means he will overpay by £42 each month, reducing the capital more quickly and reducing the interest charged. The lender calculates that if this overpayment continues for the rest of the mortgage term, the mortgage will be repaid two years early.
Six months later, the lender’s rate increases to the original level and John decides to maintain his existing payment. He will have paid off a very small amount of additional capital by overpaying for a short period, but not enough to make a significant difference. As a result, the lender’s recalculation will show that, if this payment continues for the rest of the mortgage term, the mortgage is now likely to be repaid only a month or so before the original end date, now 18 years and six months away
What are interest only mortgages?
With an interest‑only mortgage, the borrower makes monthly mortgage payments consisting of interest only. The full capital amount remains outstanding during the mortgage term and is repaid in one lump sum at the end of the term
WHAT IS A ‘PURE’ INTEREST‑ONLY MORTGAGE?
An interest‑only mortgage with no repayment vehicle.
Rare. Applies where there is a degree of certainty that the mortgage can be paid off without relying on speculative sources (ie, possible inheritance or a change in the base rate) An example is the eventual sale of the mortgaged property as the repayment method, but only where the value of the property should be sufficient to repay the mortgage. The lender cannot allow for house price inflation as part of the calculation, so the LTV of
such a loan would be relatively low#
Pure interest only mortgages are rare
Tell me the advantages/disadvantages of interest only mortgages
Advantages: A wide variety of investment
products can be used as repayment
vehicles to build up the capital
If the repayment vehicle performs
better than expected, it may be
possible to repay the mortgage early
Disadvantages:
No capital is paid off during the
term, which means the debt does not
reduce
There is a significant risk that the
chosen repayment vehicle will not
produce sufficient capital to repay
the whole mortgage at the end of the
term, so interest‑only mortgages are
not suitable for the risk averse
The total interest payable over
the term is much higher than a
repayment mortgage (this is because the capital balance is not paid off at all over the term unlike with capital repayment mortgages, so interest is charged against a higher amount resulting in much more interest being paid overall)
What is the technical term used for the frequency
of calculation of interest (ie, is the interest paid daily, monthly, annually)
rest
if a loan charges interest calculated monthly it would have monthly rest
Repayment mortgages interest is calculated as daily rest, monthly rest or annual rest.
Tell me how these different options affect the mortgage
Annual rest:
- Interest calculated annually at year start
- Payments credited as paid but deducted from the balance at the year’s end
- Most interest paid over the term: slowest debt reduction
Monthly rest:
- Interest calculated monthly at month start
- Payments credited and deducted from the balance monthly
- Less interest over the term
Daily rest:
- Interest calculated daily
- Payments credited and deducted from the balance immediately
- Potentially least interest over the term and quickest debt reduction
Explain why a mortgage with an annual rest will result in the borrower paying higher interest than a mortgage with a daily or monthly rest.
In mortgages with annual rest, interest is calculated based on the outstanding balance on a single day in the year.
For interest calculation purposes this effectively means the balance stays the same for a year. (even though it is decreasing after each repayment) When the next interest calculation comes around, it will then be based on whatever the balance is at that time for 1 year and so on. Because of this, you are effectively paying interest on money you no longer owe
For daily rest mortgages, interest is calculated against the balance each day so the balance the interest is calculated against is always taken in to account
NOTE: This is exactly the same reason interest only mortgages charge a much higher rate of interest than all repayment mortgages. It is because the outstanding balance is not taken into account so interest is always calculated against the principle amount (, the initial amount borrowed)
FEW LENDERS DO ANNUAL REST MORTGAGES NOW
WHAT IS THE SECOND APRC?
For MCD regulated mortgages there is an additional requirement.
Where the rate of interest or charges applied to the mortgage are variable, the lender must include a second APRC figure in the ESIS or as part of the KFI top‑up.
The calculation provides a warning about the possibility of an increase in interest rates
or charges and the effect they may have
