Repayment Mortgage Loans

Repayment Mortgages are alternatives to Interest Only Mortgages, and are sometimes called Capital Repayment Mortgages. They are the most common type of mortgage in most countries with Anglo-Saxon property laws such as the US and UK.

Mortgage Loan

The principle of repayment mortgages is that each month a little bit of both the capital (or principal) and the interest is paid. The aim is that all the principal is paid off at the end of the term of the loan. Usually the term is set at something between 20 and 30 years. Many people take out mortgages when young, and their aim is to pay it off by retirement.

The monthly payment is determine using a complicated formula which is established to ensure that no capital is owed at the end of the term. Consider a property costing $250,000 which is mortgaged for $200,000, the remaining $50,000 being a deposit. A 20 year loan has the aim that the full $200,000 is paid off after this period. This differs from interest only loans where no capital is paid during the period of the loan, only the interest on the capital or principal.

The monthly repayment for a mortgage is calculated using:

  • the interest rate
  • the original amount of the loan
  • the term of the loan

Mortgage Rate Calculator

A $200,000 loan typically involves paying:

  • $955 per month at 4% annual interest over 30 years
  • $1212 per month at 4% annual interest over 20 years
  • $2025 per month at 4% annual interest over 10 years
  • $1199 per month at 6% annual interest over 30 years
  • $1433 per month at 6% annual interest over 20 years
  • $2220 per month at 6% annual interest over 10years

If your loan is $100,000 then the amount payable is exactly half that above, for a $500,000 loan it will be two and a half times.

You will notice several things.

  • The first is that the amount payable is not proportional to interest rates, otherwise the monthly payment for a 6% loan will be one and a half times that of a 4% loan.
  • The second is that the amount payable is not proportional to the term of the loan, otherwise the monthly rate of a 20 year loan would be half that of a 10 year loan.

This is because part of the monthly payment is capital and part is interest. For a $200,000 loan at an annual interest rate of 4% over 20 years:

  • at the beginning of the loan you owe $200,000
  • after the first month you pay $1,212
  • however the interest on the first month is $200,000 x (0.04/12) or $667 : that is because at the beginning you owe $200,000 so the monthly interest on this is a twelfth of 4%
  • therefore the amount of capital you owe is $200,000 (the original loan) – $1,212 (the monthly payment) + $667 (the interest) or $199,455
  • hence in month 1 in addition to $667 interest you pay $545 capital
  • in month 2, you still pay $1,212 but the amount of interest is slightly less because you owe $199,455 instead of $200,000: it is in fact $665 and so the amount of capital you repay that month is $547
  • If the term of the loan is shorter, e.g. 10 years compared to 20, the relative amount of capital paid is greater each month compared to interest, and so the amount owed reduces faster each month. Hence overall the total of interest over the term of the loan is less, as the amount owed reduces faster.
  • If the interest rate is higher, this only influences part and not all the amount paid each month.

As time goes on the monthly payments consist more of capital and less of interest. Therefore in the first few years of a loan, the payments are primarily interest, and towards the end they are primarily capital.

Decisions About Repayment Mortgages

There are several decisions that need to be made.

  • Should a mortgage be redeemed or paid off before it finishes, by paying the remaining capital you owe so it is finished early? If this is in the early years this saves a lot of interest, but if later, the amount of interest saved can be small and it may be beneficial to save up or invest the money elsewhere. Often people say they are relieved if they get a lump sum and use it to pay off their mortgage. However, if you have a 20 year loan for $200,000 at 6% interest and pay the remaining capital off after 5 years, you will be saving $88,116 interest in total, but after 15 years, you save only $11,856. Perhaps the $11,856 (or $2,371 per year) could be better invested or spent on family holidays and so there is not much point at that stage.
  • The term of the mortgage needs considering. A short term mortgage is less costly overall than a long term mortgage. For example a 10 year mortgage on $200,000 at 4% per annum costs a total of $242,988 whereas a 20 year mortgage costs $290,871 over its lifetime. If you can afford the monthly payments go for the shorter term mortgage, however once you have fixed the term, most lenders do not allow you to change the term unless you refinance your property, often at significant costs.
  • Flexibility. A few lenders do allow you to increase or decrease the rate of capital repayment over time. This flexibility often comes at a cost, in that the mortgage is more expensive.

The calculations above are quite straightforward to generate using standard online mortgage calculators, but there can be hidden complexities that vary between lenders.

  • For example, interest rates may change. The way lenders handle this can be quite complex.
  • A few lenders calculate interest annually rather than monthly. This can lead to higher actual repayments for the same apparent interest rates.
  • The calculations do not take inflation into account. Today’s dollar or pound does not hold the same real value to tomorrow’s dollar or pound as inflation eats away – this makes mortgages in practice cheaper in the long term than a calculation may suggest.