Repayment Methods
You will need to have paid off your mortgage by the end of the term which normally lasts for 25 years. It is important for you to understand that your mortgage is made up of two main components:
- The capital sum (i.e. the amount you borrow to buy your home), and
- The interest the lender charges you for lending you the capital to buy your property
You have a choice of two repayment methods.
Repayment (capital and interest)
This is the most popular method and the route most borrowers prefer to take in order
to be sure the loan is fully repaid at the end of the term.
Your monthly payments cover both the repayment of the capital sum borrowed and the interest due on your loan.
In this way, you gradually pay off the full amount of your mortgage over the term. In the early years, your payments will be geared more to paying off the interest, whilst in the later years, most of your payments will be repaying the capital sum.
As long as you make all the monthly payments, you can be certain that the whole loan will be repaid by the end of the term. You can see this in the graph:
As you can see from the graph, the amount of capital you owe reduces in a capital and interest mortgage so that by the end of 25 years you will have paid off your mortgage and owe nothing.
Interest-only
Your monthly payments cover only the interest due on your loan. Therefore you will need another means of repaying the capital borrowed by the end of the mortgage term.
Repayment of the capital sum can be from a separate savings plan or investment, such as those shown below:
- Pension - this is repaid at retirement, when a certain proportion of funds accumulated in a pension plan may be taken as a lump sum, currently free of income tax and capital gains tax.
- Individual Savings Account (ISA) - this is a tax-free savings account.
- Endowment Policy - this is a specialised long-term investment which also provides life cover during its term.
However, you must be aware that the value of investment plans can go down as well as up and cannot be guaranteed on maturity (when they finish). This makes an interest-only mortgage a more risky option than a repayment mortgage.
In this graph, the line representing the amount of capital outstanding is the same through out the 25 year duration instead of decreasing as in the previous graph. This is because in an interest only mortgage you never pay off any of the capital you owe each month and hence the amount you owe after 25 years will still be exactly the same as it was in the beginning.
Your responsibility...
It is your responsibility to make sure you have enough money to repay the mortgage loan at the end of its term.
You are not obliged to take a repayment vehicle in connection with your loan but you should not over-rely on a means of payment that may only be a possibility.
As you will only pay interest, your monthly payments will be lower compared to the repayment method, but you also need to take into account the cost of any savings vehicle.
By taking this option your mortgage balance will not decrease, so there will be more interest overall to be paid, compared to the repayment method.