Capital & interest
The most common way to repay a loan is to make
regular payments of the capital (also called principal)
and interest over a set term. This is commonly
referred to as (self) amortization in the U.S.
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 U.S., 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 Personal Equity Plan (PEP)
mortgage, Individual Savings Account (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 dependent
on the investment making sufficient return to
clear the debt. It
is not uncommon for interest only mortgages
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,
depending on the country. 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 U.S. 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 and interest (repayment) basis. |
