A mortgage is a loan, secured on the value of a property, which you pay back over a given period of time. 'Secured' means that if you don't make payments as you agreed, your mortgage provider has the right to sell your property in order to recover their money. This is the first reality of mortgages: you must repay your mortgage in accordance with the terms of your loan.
The usual term of a mortgage is 25 years, but this can be longer or shorter depending on your individual circumstances. The initial amount you borrow is called the capital, and there are two main ways of paying this amount off. As with most loans, you will accrue interest on the capital, so you will need to pay that off as well.
One way to pay off the capital: repayment mortgages
Repayment mortgages are the only way to guarantee that the property is yours at the end of the term. This is because with a repayment mortgage, every payment you make chips away at the capital itself and the interest due at the end of the loan. If you stick to the terms of your repayment mortgage, your final payment will leave you the free-and-clear owner of your own home.
With a repayment mortgage, your mortgage payments initially pay off mostly interest, so if you sell up in the early years you'll find you've hardly paid off any capital at all, which can be a bit disheartening. But hang in there for a few years and you will find yourself whittling away at more and more of the capital. Many lenders offer flexible repayment mortgages that allow you to overpay when you can afford to and take 'payment holidays' when you can't.
Without doubt, a repayment mortgage is the surest and safest way to see off the loan. It's the best option if you absolutely, categorically, do not want to risk the roof over your head. You borrow the money and you pay it back in installments - it's as simple as that.
A different approach: interest-only mortgages
Unlike repayment mortgages, with interest-only mortgages, the monthly payments you make to the lender are solely directed at the interest owed. You don't pay off any of your capital debt during the term of the mortgage – you only pay off the interest on that debt. So at the end of the mortgage term, you still owe your lender the original sum you borrowed.
If you’re a disciplined borrower, an interest-only mortgage shouldn’t pose a challenge come the end of the term, as you will be ready to repay the capital. The best practice is to make monthly payments into an investment fund at the same time as you make payments to your lender. If your investments grow as hoped, by the end of your term you should have enough to pay off the capital sum of the mortgage, and maybe even a little extra.
One way of doing this is to buy a low-risk fund, such as an index tracker, and hold it within the tax protection of an ISA. When the 25 years are up, you hand over the relevant sum from your ISA - and the house is yours.
There are pros and cons to interest-only mortgages. The up-side of an interest-only mortgage is that if your investments do well you may be in a position to pay off the mortgage early or have some money left over. But there are no guarantees.
It's crucial that you are sensible about the amount of money you direct each month into your investment fund. Your lender may insist on agreeing a basic amount, but this does not guarantee anything. If there's a shortfall at the end of the term, it's your problem and no one else’s.
Most sobering, if you cannot come up with the funds to repay your loan, your lender can repossess your home.
The dangers of the interest-only mortgage
Recent years have seen a very worrying trend where people take out interest-only mortgages and pay down their interest but fail to save towards repaying the capital element. Instead they're relying on house prices to rise sufficiently so that they will be able to trade down to a smaller property and use the difference to pay off the mortgage. This is an extremely risky approach. It can lead to repossession and even bankruptcy.
If you take out an interest-only mortgage it is absolutely vital that you monitor the progress of your investments. If they fail to grow as hoped you may need to increase the amount you put away each month, and you will want to do this sooner than later. This may not be an option for people on a tight budget, so think carefully about how much financial flexibility you have before taking out an interest-only mortgage.
Complicating things further, as your monthly payments to the mortgage provider solely consist of interest, they will vary considerably if the rate of interest changes. This is good if interest rates fall, but not so much if they rise.
Another option is to get an interest-only mortgage, but make overpayments every month. This will give you the flexibility of lower monthly payments, if you need them, but should keep you on track to pay off your capital debt as well.
Another kind of interest-only mortgage: endowments
An endowment mortgage is another form of interest-only mortgage. The endowment policy is a combination of savings, investment and life assurance all tidily wrapped up in an insurance policy. The life assurance is there to ensure that the mortgage is paid off in the event of your death.
Endowments are rarely sold nowadays because many have failed to meet expectations, due to falling investment returns. If you had a straightforward interest-only mortgage, falling investment returns would prompt you to increase the amount you pay into your investment fund… and in fact, the same is true with endowments. However, many policy providers have been slow to communicate this, and so many borrowers have received letters warning that their endowments may not cover their mortgage.
To make matters worse, many endowments were mis-sold (for example, people were told that the policies were guaranteed to pay off their mortgage when this was never the case).
So that’s why we don’t like endowments here at lovemoney.com. We see endowments a underperforming, expensive, inflexible investments and we’re pleased that in view of their growing unpopularity, very few mortgage lenders now offer them.
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