Repayment / Interest only question

Dick_here

We took out a new repayment mortgage last year. I've also got an endowment that's due to pay out in 6 years time.

Seeing as during the early years of a repayment mortgage you're hardly paying off any capital anyway (yet you pay well over the interest only odds each month for the privilege of not doing so), wouldn't I be better to switch to interest only until the endowment pays out and I can wipe off a big chunk of capital in one go ?

As it stands, I feel like I'm paying extra for a few years for no real benefit. Am I missing something though ?

Soph

Hi !!!!!! here

I hope this clarifies it a bit for you...

What you've said is partially right, ie that during the early years you're hardly paying off any capital. However, you are still paying off some capital, it's just that the proportion of capital to interest that your mortgage payment covers is more heavily weighted towards interest in the early years. As time goes on that proportion gradually swaps over, so that in the later years your mortgage payment is more capital than interest.

Say you've got a mortgage that calculates interest monthly (1/12th). When it starts your repayment mortgage payment is set at £500 and in the first month your interest charge is £450, therefore £450 of your payment is to pay off interest and £50 of your payment is to reduce your capital balance.

The next month you still pay £500 but your 1/12th interest is calculated on a balance that is now £50 lower than the last month so in the second month £445 of your payment may be to cover interest and this time £55 of your payment reduces the capital. Thus the following month the interest is calculated on a balance that is £55 less than the month before and £105 less than it was when you started, and so on and so forth thoughout the term of the mortgage...

This is clearly a very simplistic way of looking at it (and assumes that interest is calculated on a 1/12th basis at the beginning of each month, although the principle's the same if your mortgage interest is calculated daily) and I've not 'calculated' these figures at all, merely chosen numbers to to illustrate how a repayment mortgage payment eventually pays off the mortgage.

I hope this helps explain about the interest. Clearly, if you do swap it to interest only, you will literally only be paying the interest and you will not reduce the capital at all, until you pay off the endowment pay out and then convert it to repayment (at which point your payment will be higher than what it would be if you had been on a repayment basis from the beginning as you'll have the same capital to repay but over 6 years less.)

I hope this makes sense. I guess it will come down to your cash flow priorities in the short term against your longer term mortgage repayment plans. Feel free to ask any questions you've got or for more explanation if you'd like.

Soph

Ps. Just thought, if you dig out the KFI (Key Facts Illustration) you received when you got the mortgage, there will be a summary of mortgage payments on the last page, which will show you how your balance will drop each year towards the end of the mortgage term. Have a look at how much your mortgage is likely to reduce by in 6 years time and, in essence, if you continue on a repayment basis, you will be that much better off in 6 years than if you convert it to interest only and don't pay off any capital in 6 years.

homer_j_3

Not all kfi's have that table on.

The benefit of repayment is that it will be repaid at the end and in the first few years you will reduce balance slightly. There is little benefit in the short term but that said, the short term has to become the medium or long term at some point so you have to go through this.

You are not missing anything, you either want to ensure your mortgage is paid off by paying each payment on time over the full term or you want to take the risk of an investment vehicle and pay the extra into that instead.

Dick_here

Thanks for those replies, excellent.

So am I right in thinking that it boils down to the extra monthly cost of repayment for 6 years (in my case) against the amount of capital that will be paid off by paying it for that period ? If the former is higher than the latter, then I should switch to interest only for the portion that I know the endowment payout will cover (if not all of it) ?

Is there a calculator for this somewhere ?

Soph

I guess so, although the capital reduction should be greater than the difference between an interest only payment and your repayment payment over the same period.

Would be interesting to see what the difference (or benefit!) actually is...

I'm afraid I've no idea whether there are any calculators anywhere for this comparison specifically, but it would be very simple to work out the payment difference:

Your mortgage balance multiplied by the interest rate%, divided by 12 = monthly interest only payment

Your current payment minus the interest only payment = monthly 'difference'

Multiply the monthly 'difference' by 72 to get 6 years worth of 'difference'.

This should be less (probably not by a huge amount) than the amount your mortgage is projected to reduce by in 6 years on your KFI. Bear in mind that for a fair comparison, you'll need to use the same balance and interest rate at the start of the above calculation as that which your current payment is based on.

Of course, this is based on today's figures and doesn't take into account any changes in rate, payment or balance that may occur over the 6 years, but it will still give you an idea. Like homer_j said, the reduction will be gradual and not hugely significant in the early years but the short term does have to become medium and long term at some point and effectively, you would just be postponing paying off the capital.

Hope this helps...

Soph

Was almost forgetting about the endowment policy...!

There'd be nothing stopping you converting the end pol amount of the mortgage to interest only if you're sure the end pol will cover it, but if you keep the full mortgage on repayment as it is now, your balance when you come to pay off the end pol payout will be lower (maybe only slightly but still lower!) than it would be if you convert part or all of the mortgage to interest only now.

It will come down to how high up your list of priorities is paying your mortgage off as quickly as you can.

Why don't you call your mortgage lender and ask for some illustrations (KFIs) on converting your mortgage to part interest only/part repayment or even full repayment, so you can compare them.

Sorry if this is getting a bit in depth - I do tend to get carried away when talking about interest!

InMyDreams

Soph wrote: »

I guess so, although the capital reduction should be greater than the difference between an interest only payment and your repayment payment over the same period.

Would be interesting to see what the difference (or benefit!) actually is...

Huh???
There is no difficult calculation to make. Whatever you pay over and above the interest is capital repayment. End of.

Or am I misunderstanding the question?

Dick_here

InMyDreams wrote: »

Huh???
Whatever you pay over and above the interest is capital repayment. End of.

Hardly. If it was that simple, your outstanding mortgage would go down by that amount each month throughout the term. But it doesn't, does it. it goes down by very little early on and increases.

Gorgeous_George

!!!!!!

Let me know the interest rate, term and loan amount and I will tell you how much capital you are repaying each month. If you have Excel, I'll email a spreadsheet.

GG

InMyDreams

!!!!!!_here wrote: »

Hardly. If it was that simple, your outstanding mortgage would go down by that amount each month throughout the term. But it doesn't, does it. it goes down by very little early on and increases.

No, you pay large amount of interest early on because you owe much more. Once you've cleared the interest, the rest is pure capital repayment. Nothing is 'lost'. If you go interest only, the interest stays the same (or would if the rate stayed the same) as you are not reducing the capital.

I'm sure GG will be able to explain it admirably

Gorgeous_George

Have you considered selling the endowment policy and using the money to reduce the mortgage? If you have a poor performing endowment, this can be good money-saving.

GG