Repayment vs interest only mortgages

CBGX

Hello - I last got mortgaged in the 1990's and I remember then that repayment mortgages used the 'sum of digits' method to calculate capital repayments. Broadly this meant that expected interest and capital repayments were added up and divided by the number of monthly repayments (25 yrs x 12 months = 300 payments) and then the interest was front loaded and capital repayments back end loaded. So in the first month you repaid 1/300th of the principal amount and 299/300th of the interest bill. For the first 5 years this meant that you repaid virtually no capital, so if you moved frequently, you never paid off the capital. It was a mini-scam that the mortgage lenders ran.

As a result of this many people who moved frequently took out interest only mortgages and repaid their principal loans either at maturity or along the way when they could. It meant that when you moved house, Onan interest only mortgage you had not overpaid interest to the lender.

Is this still the same with modern repayment mortgages? If so, how do lenders get away with it?

MorningcoffeeIV

CBGX said:

Broadly this meant that expected interest and capital repayments were added up and divided by the number of monthly repayments (25 yrs x 12 months = 300 payments) and then the interest was front loaded and capital repayments back end loaded. So in the first month you repaid 1/300th of the principal amount and 299/300th of the interest bill. For the first 5 years this meant that you repaid virtually no capital, so if you moved frequently, you never paid off the capital. It was a mini-scam that the mortgage lenders ran.

No, it wasn't a scam and the interest wasn't front loaded.  It's simply a way to make loans affordable to people, as very few people could afford to clear all the interest and a fixed percentage of the capital in the early months.

It's also not true that the mortgage would never be paid off if you moved frequently.  More capital is paid off over time, as the balance reduces, thus generating less interest. 

Interest only didn't mean paying less interest. In reality, of course, it mean paying more, as the balance remained at its initial amount. You needed to hope that your investments would outperform the mortgage rate.

silvercar

I'll ask the forum team to move this over to the Mortgage Board.

MEM62

CBGX said:

Is this still the same with modern repayment mortgages? If so, how do lenders get away with it?

The system still works this way but it is not a scam and they is nothing "to get away with".  Your theory that it it is a scam based on your misunderstanding of the way that mortgages work.  

MSE_ForumTeam5

Moved as suggested by @silvercar

CSI_Yorkshire

This strange suggestion of mortgage lenders "deliberately putting all the interest at the start" has come up a couple of times recently - I wonder if there's been a blog post somewhere that's triggered it.

That's just how a loan repayment works if you are using a fixed monthly payment.

In the first month, you are paying interest on the full amount of the loan.  This is a big number.

In the second month of an interest only mortgage, you are still paying interest on the full amount of the loan.

In the second month of a repayment mortgage, you are paying interest on a little bit less than the full amount because you have paid off some capital.  This is still a big number, but it's slightly smaller than the last one.

Follow that pattern through the rest of the months, and you pay a lot more interest on the first option than the second (assuming the %s are the same).

The other option would be that you split the capital equally and then paid whatever extra interest was due in the month.  That makes each payment slightly smaller than the last - but most people don't like that idea (especially as your free cash flow usually tends to increase through a mortgage so is most constrained at the start).