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Repayment

Repayment is the traditional means to pay back a mortgage – you make payments every month, part of which goes towards repaying the money you have borrowed – the capital – and part of which pays the interest on the loan (also known as capital and interest mortgage). Instalments remain the same each month, changing only as the Bank of England interest rate rises or falls and lenders’ interest rates follow suit. The advantage of a repayment mortgage is that provided you have kept up with the monthly payments you are guaranteed to have paid off the loan by the end of the mortgage term.

In the early years of a repayment mortgage, more of the instalment goes on paying the interest than the capital. Over time, as more of the capital is paid off, so the amount of interest reduces until the total loan has been paid back.

Since you will be paying back both capital and interest, monthly payments to the lender on repayment mortgages tend to be higher than for interest-only loans. But interest-only loans also require payments into an investment plan such as an endowment, a pension or an individual savings account (ISA).

Interest-only

With an interest-only mortgage you do not pay back any of the capital until the end of the mortgage term. You pay the lender interest on the loan each month.

Repayment of the capital is usually covered by long-term payment into an investment scheme, designed to have accumulated sufficient returns by the end of the term to pay off the loan – and even to have grown to give you a surplus lump-sum payment too.

There are various types of investment schemes used to cover an interest-only loan:

Endowment

With an endowment mortgage you pay interest on the loan to the lender and premiums into an investment plan. These plans are usually run by insurance companies and include life cover. They are designed to pay off the capital at the end of the mortgage term or if you die within that term.

However, much depends on the performance of the fund into which your monthly payments are invested. Many people who took out endowments during the 1980s when stock markets and percentage returns on investments were high, have found that the low returns of the 1990s and since have left them with a current shortfall and the possibility that the endowment will not meet the payment of the loan at the end of the mortgage term, let alone provide them with a welcome lump sum over and above that.

ISA

With and ISA (individual savings account) mortgage you pay the interest on the loan each month and invest in an ISA, the casing in of which pays off the mortgage at the term-end. ISAs have the advantage of a number of tax benefits but there is a limit on how much can be invested into an ISA each year. ISAs can be invested in the stock market, life insurance policies and cash.

Pension

These are available to the self-employed and those contributing to a personal pension plan but not as part of company schemes.

With pension mortgages the capital sum remains outstanding for the length of the loan, on which you pay interest. Payment of the loan is met at the end of the term from the pension plan.
The advantage of a pension mortgage is that you can claim tax relief on any contributions made to the pension plan. The disadvantage is that you are paying for your home loan until you retire, setting your retirement age in advance. You are also using part of your pension to pay for your mortgage. And only 25 per cent can be taken as a lump sum – the rest must be used to purchase an annuity.