When applying for mortgages borrowers have the choice of obtaining interest only or repayment mortgages. Interest only mortgages require the borrower to only pay the interest charged each month on the mortgage. The balance of the mortgage remains the same throughout the entire term of the loan.
With repayment mortgages, the monthly payments to the lender comprise an element of interest charged and an element of capital repayment. As long as all the repayments are made on time, repayment mortgages are guaranteed to be repaid at the end of the term. Repayment mortgages are also known as “capital and interest mortgages” because the capital balance is repaid along with the interest payments.
During the term of repayment mortgages the monthly payments made to the lender comprise both an interest portion and a capital repayment portion. At the beginning of the term of the mortgage the interest portion is high and the capital portion low. Over time the interest portion diminishes and the amount of capital repaid increases. At the end of the term of repayment mortgages, the capital portion should be fully repaid.
Repayment mortgages are less risky than interest only mortgages because there will be no outstanding balance at the end of the term. Borrowers will therefore not be required to establish a separate Capital Repayment Vehicle (CRV) such as an endowment policy. Home owners with repayment mortgages are also less likely to suffer from negative equity because they will be constantly decreasing the capital portion of their loan.
Regardless of the reduced risk, borrowers of repayment mortgages should take out decreasing term assurance policies. This type of assurance policy reduces the sum assured roughly in line with the reducing mortgage balance. This will insure that the balance of the loan is repaid upon death of the borrower. By selecting the right type of assurance policy, the borrower will insure that the balance of the mortgage is paid off in full either when the term of the mortgage expires or upon death if they die during the term of the loan.
One disadvantage of repayment mortgages is that the amount of the monthly repayment will be higher than for interest only mortgages. This is because the borrower will make payments towards the capital balance as well as the interest each month. This can make repayment mortgages difficult to afford for first time home buyers and home owners with tight household budgets.
Home owners who opt for interest only mortgages should consider switching to repayment products at some point to ensure they eventually pay off their homes. If the balance of the loan is not paid off during its term the home owner will need to have established a CRV that will pay off the balance for them.
Repayment mortgages therefore have both advantages and disadvantages and borrowers should be well informed of both before applying. Independent mortgage advisers can help borrowers who cannot decide whether to apply for interest only or repayment mortgages by providing expert and impartial advice. Once the assessment has been complete the mortgage broker can assist the home owner in selecting the most appropriate product for their personal needs.
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