Mortgages Minus the Mystery
Dealing with mortgages is as easy as telling the time.
£833.33. This number looks as if some complicated mathematical formula produced it. Actually it represents the monthly interest due on a loan of £100,000 at 10%.
Why so many threes? Why an odd number when a multiple of 10 seems more logical? And if we try to understand the underlying maths, will we get a headache?
The underlying maths are really simple.
Ten per cent of £100,000 is £10,000. If there were only ten months in the year, the monthly installment would be £1,000. Because we pay monthly and there are 12 rather than 10 months to the year, each payment is 1/12 of £10,000 - which comes to, yes, £833.33.
And that is the amount of interest you pay whether your loan is for one, five, ten or twenty-five years.
And the same maths apply whether the interest rate is one per cent per month, or 15.75 per cent. The amount of the loan multiplied by the interest rate (such as £100,000 times 10%) gives you the annual interest due. Then divide by 12 to get the monthly amount.
If you have an interest-only mortgage, your payments are credited only as interest. Your principle (capital) remains unchanged, so if your loan was for £100,000, you still owe £100,000 when the term ends and you have paid all the interest.
A repayment mortgage is different. You pay the interest as described above - and you also pay an additional amount. This extra amount is credited against - and helps reduce - the principle.
Repayment mortgages usually have these features:
1. Length of Term: The longer the term, the less you pay per month, but the more you pay in total.
2. Principle (capital) versus Interest: You pay a lump sum part of which is considered interest, and part is principle. However, in the early years of your payments, most of that lump sum goes toward interest. Your principle does not get reduced by very much. In these earlier years, you pay a lot of money and you still owe a lot.
But this pattern reverses toward the end of the loan, when most of your payments lower the principle that you still owe. In these earlier years, you pay a lot of money and your loan reduced by a lot. At the end of the term, you have paid all the interest you owe, and you have also paid off all of the principle. You own your property, you own nothing.
Can You Explain Length-of-Term Again, Please?
OK, suppose a £100,000 mortgage at 10 per cent. How much do you pay per month?
Loan A: Interest-Only. £100,000 at 10 per cent.
For one year: £833.33/month.
For ten years: £833.33/month
For twenty-five years: £833.33/month.
However short or long the term, you pay £10,000 per year and still owe the full £100,000 at the end. This amount is usually paid off by another savings vehicle into which you have been paying.
Loan B: Repayment Mortgage (paying interest and principle). £100,000 at 10 per cent.
For one year: £8791/month. Total payment: £105,492.00
For ten years: £1322/month. Total payment: £159,640.00
For twenty-five years: £909/month. Total payment: £272,700.00
At the end of the term, you owe nothing. If it was for one year, you paid £5,492 interest, whereas if it was for 25 years, you paid £172,700 in interest payments alone.
Repayment Mortgages – from Tortoise to Hare
After your first year of paying off your repayment mortgage, you may feel that you paid an awful lot of money and have very little to show for it. This feeling will be justified. The principle will have barely budged downward. Where did all your money go?
When you start repaying a repayment mortgage, most of your payments are interest, and relatively little pays off your principle.
But over time the pendulum swings, and near the end, most of your payments reduce principle.
Here is an oversimplified example: a borrower with a repayment mortgage pays £6,000 per year (£500/month) to the lender.
In the first year, £5,000 is credited as interest, and only £1,000 is credited against principle. So if the total loan was £250,000, after the first year, it has dropped only to £249,000. That can hurt.
But - In the final year, again, the borrower shells out £6,000, but now £5,000 is credited against - and reduces - the principle, and only £1,000 is interest. In the final years, the principle drops rapidly.
Payments Methods and Risk
When property prices seem only to rise and never to fall, many borrowers are tempted to take out interest-only mortgages and pay off the capital from all the profit they make when they sell.
In fact, there is no guarantee that prices will rise, and they well may fall. In fact, property prices started doing just that near the end of 2007 after many years of steady rises. After several years of steady increases, the rate of house price rises slowed, and in some areas actual prices started falling too.
And because this risk of falling prices is real, lenders are cautious with interest-only loans. They will restrict the value of the loan – for example, by giving you a maximum of 60 or 70 per cent of the property’s value.
Interest-Rate-Only is Not Necessarily Cheaper by the Month
Many so-called interest-only loans are not quite what the label indicates: the lender may insist that the borrower also takes out an ISA or other repayment vehicle, such as an endowment. When that happens, the interest-only mortgage resembles the repayment loan in that the borrower is in effect paying into two pots: one for interest, the other for principle.
The Bargain that Isn't
A theatre club charges you a £5 membership fee and £10 for a ticket to see a show. Total cost to you: £15.
New policy: no more membership fee. Tickets still cost £10. Total cost to you: £10. You have a genuine saving of £5.
But what if they drop the membership fee but raise the ticket price to £16? Total cost to you: £16. There is no membership fee but you are paying more than when there was one.
How does this example apply to mortgages? Consider Higher Lending Charges. A lender may not apply an HLC at all, which looks like a saving for you. And it might be if, like the theatre club, they are genuinely removing the fee and not adding anything else in its place. But to qualify for this fee-free loan, you might have to pay a higher interest rate - one that leaves you worse off than if you paid a fee.
Look behind the headline rate; look at all of the fees, terms, costs and other relevant factors. Study the 'Key Facts' carefully, and absorb as much of the small print as you can.
Remember, too, that when a lender 'gives' you something, they generally take something away elsewhere—and not infrequently, they take back more than they give.
The Free Lunch that Isn't
First-timers and other hard-pressed borrowers are often attracted to cashback mortgages: you get £5,000 or so in cash to buy furniture, for example.
This cash may appear to be free but it is not. It is a loan—on top of that other loan known as your mortgage. You will have to pay interest on it—above and beyond the interest you will have to pay for your basic mortgage. And over the long term you will pay handsomely for a cashback. But for some first-timers and other financially-stretched buyers, the short-term gain justifies the long-term pain.
The same principle holds with discounted initial interest rates. Somewhere down the line you will pay extra for that early gift. Usually, the more that you receive early on (whether as cash or in lower monthly payments), the more you pay later.