-How to repay mortgage: repayment options

Continuing further from the previous article Home loan or mortgage plan selection, let’s talk today about the options you have to repay your mortgage or loans.

Once you have decided to take a mortgage, you must select a plan for repayment.

You can choose to pay your mortgage back in the following ways:
• repayment;
• interest-only; or
• a combination of the above two

Let’s discuss them in detail:

Repayment (also called a ‘capital-and-interest’ loan)

Basically, your mortgage liability consists of 2 parts:
• The principle amount (or capital amount) that you borrow as mortgage or loan
• The interest that you have to pay on the above principle amount, over a period of mortgage term

The payments you make to the lender every month reduce the principle/capital amount you owe as well as paying the interest on the loan. So each month you pay off a small part of your mortgage.

It’s a very simple and crystal clear approach – you can see your loan getting smaller. If you make all the agreed payments on all the agreed timings, the loan will be fully paid off by the end of the mortgage term.

However, one thing to be noted here is that in the early years your payments will be mainly interest. The reason for this is that since your principle or capital amount is high and close to the actual borrowed amount, the interest that you have to pay will also be high. Hence the payments that you will make while repayment will mainly go towards interest repayment and remaining small portion will go towards principle/capital repayment. As you carry on making repayments, gradually the interest component will reduce and hence more money will be going to the principle repayment.

The reason for mentioning the above point is that if you want to repay the mortgage or move house during the initial period of your loan, you’ll find that the amount you owe won’t have gone down by very much.

Interest-only

As the name suggests, your monthly payment only pays the interest charges on your loan – you don’t reduce the principle/capital amount of loan itself. Because you’re only paying off the interest your monthly payments will be lower than an equivalent repayment loan. So, one major benefit is that your monthly repayment amount will be less.

But what this means for the principle/capital amount of mortgage loan? It means that you are required to pay the actual principle/capital amount of mortgage loan at the end of the mortgage term period.
Hence it becomes very important that you arrange some other way to repay the loan at the end of the term, for example, through an investment or savings plan.

Make sure you know from the beginning how you plan to pay off the principle/capital amount of your mortgage loan.
Here are a few examples that people follow:
• Save or invest regularly with well planned strategy– so you build up a good enough amounts that will pay off the loan at the end of the term. You should check the progress of the plan regularly. If it doesn’t grow as expected, you will have a shortfall and you’ll need to think about ways of making this up.
• Switch later to a repayment mortgage. This might be a suitable option if, say, your earnings are low now but you expect them to be much higher in future. However, because you’re putting off repaying the loan you will end up paying more interest and more in total for your mortgage over the term.
• Use a lump sum from somewhere else – say, an inheritance, or selling something such as another property or a business. This may be risky – for example, how sure are you that you will get an inheritance or what happens if your business fails?
• Sell the mortgaged house to pay off the principle/capital amount of loan. This is suitable only if you won’t need to live in the property – for example, if it is a buy- to-let property or a second home, or you are buying something smaller or cheaper.

Think very-very carefully about using an investment or savings plan to build up the money you need to repay the mortgage. Think about the riskiness of your job and hence your salary – for e.g. in 2000-2001, many people were fired from their technology jobs. The mortgage loans they took was based upon the assumption that their job and hence their salary will continue. However, when they lost their jobs, they were in a financial distress.

Thinking of making money from stock market to repay your loans is also very risky. Here is a very good article telling you how stock market investments fail even in the long term. An investment plan invests in the stock market and the value of your investment can go up and down. If you are not comfortable with taking this risk, think about a repayment mortgage instead.