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The choice of repayment method
boils down to your own personal circumstances and aspirations.
A desirable facility is one that allows you the flexibility to
switch repayment methods during the life of the loan.
The various repayment methods are as follows:
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» Principal and Interest (P+I)
...
In this method of repayment, the regular repayment, be it a
monthly, quarterly or six monthly sum, would remain unchanged
during the life of the loan assuming that the interest rate
remains unchanged.
In practice, the periodical repayments would be subject to
variation owing to changes in the variable interest rate over
time.
Borrowers would find themselves having a reducing interest
payment each year and therefore reducing relief against tax as
interest on loan is a tax deductible item. This is compounded
by increase in rental income over time.
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Each repayment
contains an element of both capital and interest.
In the early years the interest portion is highest.
During the later years of repayment the capital portion becomes
higher as the interest portion falls.
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» Straight Line Principal
Repayment ...
In this method, the loan amount is divided in equal
installments, repayable monthly. Interest is collected as a
separate item on the principal outstanding.
This method requires a much larger amount of cash outflow in
the earlier years, especially when interest rates are high,
but as the principal reduces, your interest payable becomes
progressively lower, assuming the interest rate is unchanged.
This method presents a similar tax problem as that of the
principal and interest method as borrowers would find
themselves having a reducing interest payment each year and
therefore reducing relief against tax as interest on loan is a
tax deductible item. This is compounded by increase in rental
income over time.
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Compared to the
principal and interest method, you will pay a much lower amount
of interest over the life of the loan.
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» Deferred Interest or Low
Start Mortgage ...
This involves putting off to a later date the repayment of
some of the interest due. The interest may be rolled up in a
separate account or added to the outstanding capital sum and
then repaid via later payments. Thus, the principal owing may
be greater than the sum borrowed during the first few years of
repayment.
This arrangement appeals to those who:
- are currently at the lower spectrum of the income ladder
and is expecting a rising salary level over the coming
years which will allow servicing of the loan at an
increasingly higher level;
- expect an extra month’s salary or profit share in the
coming future.
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On the negative
side, this method often involves a higher than normal cost of
borrowing as the deferred portion of interest is added to the
outstanding loan, upon which interest is charged.
The longer the
deferment, the more costly it gets.
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» Fixed Interest Rate Mortgage
This involves borrowing at a fixed rate of
interest over a given period. Although this may assist in
financial management and planning, fixing for long periods
exposes the borrower to possible fall in prevailing interest
rates.
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Another variation is the capped rate loan
under which the interest rate will not rise above an agreed
‘capped’ rate during an initial period.
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» Endowment Mortgage
With this mortgage, you pay only interest
to the lender, and in order to repay the loan itself, you take
up an endowment policy with a suitable insurance company. The
endowment policy combines a guaranteed element of life
assurance cover equal to the loan amount, with a savings
(investment) vehicle designed to produce a cash sum on
maturity of the policy.
The maturity date would coincide with the
latest date that the lender requires repayment of the sum
borrowed. The cash is used to repay the loan and there could
be a cash surplus for the benefit of the borrower.
The endowment mortgage offers several
advantages:
- protection on death;
- accelerated repayment opportunity or cash surplus
opportunity should the plan grow more profitably than
originally assumed;
- portability in that it can be altered to provide for a
larger or smaller mortgage, a second property or utilised
when refinancing an existing loan by altering the
endowment premiums or taking up an additional plan or
policy.
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In this way, the loan repayments become an
investment in themselves.
The repayment monies are effectively
put to work twice, enabling you to diversify between fixed and
more liquid assets.
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» Investment Savings Fund Repayment
The
capital portion of the monthly repayment would be invested. At
the end of the repayment period, the accrued amount, together
with any profits, would be used to repay the full amount of
the loan, whilst the balance would be paid to the borrower.
As with the life-linked endowment, monthly
cash outflow may be higher than with simple principal and
interest repayment.
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This method is similar to the life-linked
endowment mortgage without the associated life cover.
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» Interest Only Repayment
Under this form of loan repayment
arrangement, only interest is paid on a regular basis and
there is no schedule for the repayment of capital, which may
normally be repaid in part or in full at any time.
This method alleviates the problem of
reducing tax relief experienced in both the principal and
interest method and the straight line principal repayment
method as the loan amount remains the same throughout the
specified period thus enabling you to maximise your claim for
relief against tax liability on rental income.
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This option
may be more acceptable to lenders when the client is seeking
to borrow a lower percentage of the purchase price or has
additional security, such as deposits or investment portfolio,
to offer.
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» Lump Sum Repayment
In this method, the borrower deposits or
invests a single sum at the outset, either directly with the
lender or indirectly via an insurance-linked arrangement and
repays interest on a regular basis.
The amount placed for
investment must be sufficient given an assumed, compounded
annual growth rate, encompassing the life of the loan.
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