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Find your path in payments maze

There has been a great deal of publicity in recent years over the issue of mortgage repayment. There are two main methods – interest-only and rep-ayment or capital and interest mortgages.

Interest-only mortgages involve a borrower in making payments of interest to the lender with no repayments of capital.

The loan is instead repaid at the end of the mortgage term by the cash value of some form of savings vehicle such as an Isa, an end-owment policy or a personal pension plan (including stakeholder).

Repayment mortgages require a borrower to make payments to the lender, which are partly repayments of the loan and partly interest. In the early years, the bulk of these payments consists of interest with very little being applied to the repayment of the loan.

Pundits have said that the removal of mortgage interest relief has reduced the competitive advantage that interest-only mortgages had over repayment mortgages. This is true, although the relevance of Miras was reduced even before its abolition in light of the limited tax relief available and the low ceiling on qualified loans.

The main concern over interest-only loans, however, has been the performance of the repayment vehicle.

Poor stockmarket ret-urns over the last two or three years coupled with bad publicity over charges led to serious concerns about potential shortfalls when the mortgage is due for repayment.

In some cases, borrowers with such loans have been advised to increase payments to the various investment vehicles so as to ensure sufficient capital is available. In fact, the low interest rates which have been associated with the relatively poor investment returns mean that the payments have not had to increase as less is paid to the lender.

The question which must be asked is whether the alternative, the repayment mortgage, is itself totally blameless.

Historically, lenders have offered first-time buyers a 25-year repayment term on their mortgages. On balance, someone taking out a 25-year mortgage who was prepared to make payments for the full 25-year term wanted a guarantee of repayment at the end of the term (subject to payments being maintained) and intended staying in the same property for 25 years would probably be best advised to use a repayment mortgage.

On balance, however, such an individual is probably in the minority. Many borrowers are attracted by the possibility of making early repayment by investing in vehicles such as Isas and endowments, offering the potential for substantial growth which could enable early repayment.

This is a question of risk and, if such a borrower is properly aware that investment growth is not guaranteed and that the value of such investments can fall, the interest-only mortgage route may well be more appropriate for them.

Arguably, however, even a cautious borrower may be better served by an interest-only mortgage than a repayment. This is because very few of us stay in the same property for 25 years. If we did, we would all have paid off our mortgage by the age of 50 or 55 and would be able to fully fund our pensions in the last few years prior to retirement. In fact, for many and varied reasons, we move house much more often than this. We may get married or div-orced, move home because of a new job, move to bigger home to accommodate a growing family or a smaller one as the children move out, etc. The result, for people with repayment mortgages can be expensive, with mortgage terms being extended and therefore additional interest being paid. The reason for this is in the very structure of repayment mortgages.

Repayment mortgages are set up so that, if interest rates remained constant throughout the term, the borrower&#39s monthly payments would also be the same throughout the term. The first payment would be almost entirely interest, while the final payment would be almost entirely capital.

A borrower with a 25-year mortgage who moved house after, say, five years would have barely dented the size of their initial debt and their new loan probably would be at least as large as the original loan.

To keep costs at broadly the same level as under the original loan would, therefore, require a mortgage term of 25 years. Our borrower would therefore be paying interest for a total term of 30 years. The position of a frequent mover with a repayment mortgage could be quite unpleasant.

In the case of a borrower with a similar mortgage on an interest-only basis, the position could be much less gloomy. They will have contributed to an investment vehicle for five years and would be able to transfer that vehicle (Isa, endowment etc.) to the new loan. They will not need to extend their mortgage term; if an additional amount is borrowed an increase to the investment vehicle may be required.

I would not suggest that interest-only mortgages are right in all circumstances. The borrower&#39s attitude to risk must be considered before such a mortgage is even contemplated, as must the question of cost. What I am saying is that repayment mortgages are not always the best solution.

Mortgage repayment is a major part of any borrower&#39s budget and it is important that they consider all options to determine that they make the right choice. This is one area of financial planning where getting advice from an expert is almost essential.

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