Mortgage blog: How does a repayment mortgage work?
In the years before the global financial crisis millions of people took out their mortgage on an ‘interest-only' basis. Here, borrowers would pay the interest on their loan to their lender with the intention of paying back the amount they borrowers from another source.
Now, the majority of new mortgages are being arranged on a ‘repayment' or ‘capital and interest' basis. But what is a repayment mortgage? And how does it work?
How a repayment mortgage works
Repayment mortgages are also known as 'capital and interest' mortgages. As the name suggests, you gradually pay off the amount that you borrow (the ‘capital') over the term of the loan together with interest. Each monthly payment that you make to your lender goes to reduce the amount of capital that you owe, as well as paying back the interest.
However, don't assume that each payment you make sees your mortgage balance reduce by the same amount.
In the first few years of a repayment mortgage, most of your mortgage payment goes towards repaying the interest, with only a small part allocated against the capital. Over time, the balance switches, so in the later years you pay off an increased amount of the capital each month. What this means is that you may find that you don't pay off much capital for the first few years.
On a standard 25-year mortgage it may be 15 years or so before your monthly repayment is more capital than interest.
Advantages of a repayment mortgage
The main advantage of a repayment mortgage is that, if you make your payments on time every month, you will guarantee that your entire mortgage will be repaid at the end of the term.
In addition, your mortgage balance is gradually reducing each year which means the amount of equity that you have in your home is increasing. This means that the amount you borrow as a proportion of the value of your property (the ‘loan to value') falls over time. If you decide to switch your mortgage to another lender in the future you should be able to secure a more competitive interest rate.
Disadvantages of a repayment mortgage
As we have seen, the main disadvantage of a repayment mortgage is that comparatively little capital is paid off in the early years. If you move home frequently then you may find that each time you move you've only repaid a relatively small amount of your mortgage balance.
In addition, with a repayment mortgage your payments will be much higher if you choose a shorter term. And, there is no investment component in your regular repayments. This means that there is no prospect of reducing the mortgage term other than by increasing your repayments.
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