plonkee money an english-er's thoughts on personal finance

June 27, 2007

all about mortgages: repayment and interest only

Filed under: house — plonkee @ 5:37 pm

There are a large number of different sorts of mortgage products available in the UK. In essence a mortgage is a loan secured on your house that the bank or society expect you to pay back with interest. The defining characteristics of any mortgage product are how you are expected to pay it back, and how the interest rate alters during the course of the mortgage. Today I’m just going to talk about paying back the mortgage.

There are really only two ways that you pay back a mortgage. If you take out a repayment mortgage, you pay it back a little at a time. If you take out an interest only mortgage you pay it all back at the end. In either case you pay interest only on the amount that is currently outstanding.

I think that can stand repeating, so I’ll say it again. There is really only one difference between a repayment mortgage and an interest only mortgage. With the former you pay off the original amount borrowed a little at a time (in each monthly mortgage payment). With the latter you pay off none of the amount originally borrowed, until you get to the end of the term, at which point the bank or building society expects the whole sum.

If you borrow £100,000 at 6% for 25 years with a repayment mortgage, the bank or building society will expect you to pay £644.30 every month for 25 years. In the first month, you will pay off £144.30 of the £100,000 originally borrowed, and this amount will increase every month until in the final month you pay the final £641.98. In total you will pay £644.30 x 12 x 25 = £193,290.

If you borrow £100,000 on an interest only mortgage for 25 years at 6% AER, the bank or building society will expect you to pay £500 to them every month for 25 years and then they will expect you to pay them £100,000. So all together you would pay a total of £500 x 12 x 25 + £100,000 = £150,000 + £100,000 = £250,000.

Given that you pay so much more overall to have an interest only mortgage, why would you use one?

Well, to end up with the £100,000 at the end of the 25 years needed to pay off the mortgage, you need to do more than just pay the mortgage payment each month. If you invested the difference between the two payments (£144.30) you could make it grow into enough at the end of the 25 years to cover both the £100,000 originally borrowed which needs to be paid back, and a little more on the side. All you need to do is find an investment that grows more than 6% per month on average, after tax. The biggest downside is that you are taking on a greater amount of risk in search of higher gains – especially as that greater amount of risk involves the home that you live in.

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