There are various ways to repay a mortgage loan
depending on your locality, tax laws and prevailing culture.
Capital & interest
The most common way to repay a loan is make regular payments of the
capital and interest over a set term. This is commonly referred to as
(self) amortization in the US and as a repayment mortgage in the UK.
Depending on the size of the loan and the prevailing practice in the
country the term may be short (10 years) or long (50 years plus). In the
UK and US 25 to 30 years is typical. Mortgage repayments, which are
typically made monthly, contain a capital element and an interest
element. The amount of capital included in each repayment varies
throughout the term of the mortgage. In the early years the repayments
are largely interest and a small part capital. Towards the end of the
mortgage the repayments are mostly capital and a small part interest. In
this way the repayment amount determined at outset is calculated to
ensure the loan is repaid at a specified period in the future. This
gives borrowers assurance that by maintaining repayment the loan will
definitely be cleared at a specified date.
Interest only
The main alternative to capital and interest mortgage is an interest
only mortgage where the capital is not repaid throughout the term. This
type of mortgage is common in the UK especially when associated with a
regular investment plan. With this arrangement regular contributions are
made to a separate investment plan designed to build up a lump sum to
repay the mortgage at maturity. This type of arrangement is called an
investment-backed mortgage or is often related to the type of plan used:
endowment mortgage if an endowment policy is used, similarly a PEP
mortgage, ISA mortgage or pension mortgage. Historically
investment-backed mortgages offered various tax advantages over
repayment mortgages although this is no longer the case in the UK.
Investment-backed mortgages are seen as higher risk as they are
dependant on the investment making sufficient return to clear the
debt.
It is not uncommon for interest only mortgage to be arranged without a
repayment vehicle with the borrower gambling that the property market
will rise sufficiently for the loan to be repaid by trading down at
retirement or for other less well thought-out reasons.
No capital or interest
For older borrowers (typically in retirement) it is possible to
arrange a mortgage where neither the capital nor interest is repaid. The
interest is rolled up with the capital increasing the debt each year.
These arrangements are variously called reverse mortgages, lifetime
mortgages or equity release mortgages in different countries. The loans
are typically not repaid until the borrowers die, hence the age
restriction. For further details see equity release.
Interest and partial capital
In the US a partial amortization or balloon loan is one where the
amount of monthly payments due are calculated (amortized) over a certain
term, but the outstanding capital balance is due at some point short of
that term. In the UK a part repayment mortgage is quite common
especially where the original mortgage was investment-backed and on
moving house further borrowing is arranged on a capital & interest
(repayment) basis.
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