Repaying the mortgage

 In addition to the two standard means of setting the cost of a mortgage loan (fixed at a set interest rate for the term, or variable relative to market interest rates), there are variations in how that cost is paid, and how the loan itself is repaid. Repayment depends on locality, tax laws and prevailing culture. There are also various mortgage repayment structures to suit different types of borrower.

Principal and interest

The most common way to repay a secured mortgage loan is to make regular payments toward the principal and interest over a set term.^[7] This is commonly referred to as (self) amortization in the U.S. and as a repayment mortgage in the UK. A mortgage is a form of annuity (from the perspective of the lender), and the calculation of the periodic payments is based on the time value of money formulas. Certain details may be specific to different locations: interest may be calculated on the basis of a 360-day year, for example; interest may be compounded daily, yearly, or semi-annually; prepayment penalties may apply; and other factors. There may be legal restrictions on certain matters, and consumer protection laws may specify or prohibit certain practices.

Depending on the size of the loan and the prevailing practice in the country the term may be short (10 years) or long (50 years plus). In the UK and U.S., 25 to 30 years is the usual maximum term (although shorter periods, such as 15-year mortgage loans, are common). Mortgage payments, which are typically made monthly, contain a repayment of the principal and an interest element. The amount going toward the principal in each payment varies throughout the term of the mortgage. In the early years the repayments are mostly interest. Towards the end of the mortgage, payments are mostly for principal. In this way, the payment amount determined at outset is calculated to ensure the loan is repaid at a specified date in the future. This gives borrowers assurance that by maintaining repayment the loan will be cleared at a specified date if the interest rate does not change. Some lenders and 3rd parties offer a bi-weekly mortgage payment program designed to accelerate the payoff of the loan. Similarly, a mortgage can be ended before its scheduled end by paying some or all of the remainder prematurely, called curtailment.^[8]

An amortization schedule is typically worked out taking the principal left at the end of each month, multiplying by the monthly rate and then subtracting the monthly payment. This is typically generated by an amortization calculator using the following formula:

${\displaystyle �=�\cdot \frac{�(1+�{)}^{�}}{(1+�{)}^{�}-1}}$

where:

${\displaystyle �}$ is the periodic amortization payment

${\displaystyle �}$ is the principal amount borrowed

${\displaystyle �}$ is the rate of interest expressed as a fraction; for a monthly payment, take the (Annual Rate)/12

${\displaystyle �}$ is the number of payments; for monthly payments over 30 years, 12 months x 30 years = 360 payments.

Interest only

The main alternative to a principal and interest mortgage is an interest-only mortgage, where the principal is not repaid throughout the term. This type of mortgage is common in the UK, especially when associated with a regular investment plan. With this arrangement regular contributions are made to a separate investment plan designed to build up a lump sum to repay the mortgage at maturity. This type of arrangement is called an investment-backed mortgage or is often related to the type of plan used: endowment mortgage if an endowment policy is used, similarly a personal equity plan (PEP) mortgage, Individual Savings Account (ISA) mortgage or pension mortgage. Historically, investment-backed mortgages offered various tax advantages over repayment mortgages, although this is no longer the case in the UK. Investment-backed mortgages are seen as higher risk as they are dependent on the investment making sufficient return to clear the debt.

Until recently^[when?] it was not uncommon for interest only mortgages to be arranged without a repayment vehicle, with the borrower gambling that the property market will rise sufficiently for the loan to be repaid by trading down at retirement (or when rent on the property and inflation combine to surpass the interest rate)^{[citation needed]}.

Interest-only lifetime mortgage

Recent Financial Services Authority guidelines to UK lenders regarding interest-only mortgages has tightened the criteria on new lending on an interest-only basis. The problem for many people has been the fact that no repayment vehicle had been implemented, or the vehicle itself (e.g. endowment/ISA policy) performed poorly and therefore insufficient funds were available to repay balance at the end of the term.

Moving forward, the FSA under the Mortgage Market Review (MMR) have stated there must be strict criteria on the repayment vehicle being used. As such the likes of Nationwide and other lenders have pulled out of the interest-only market.

A resurgence in the equity release market has been the introduction of interest-only lifetime mortgages. Where an interest-only mortgage has a fixed term, an interest-only lifetime mortgage will continue for the rest of the mortgagors life. These schemes have proved of interest to people who do like the roll-up effect (compounding) of interest on traditional equity release schemes. They have also proved beneficial to people who had an interest-only mortgage with no repayment vehicle and now need to settle the loan. These people can now effectively remortgage onto an interest-only lifetime mortgage to maintain continuity.

Interest-only lifetime mortgage schemes are currently offered by two lenders – Stonehaven and more2life. They work by having the options of paying the interest on a monthly basis. By paying off the interest means the balance will remain level for the rest of their life. This market is set to increase as more retirees require finance in retirement.

Reverse mortgages

For older borrowers (typically in retirement), it may be possible to arrange a mortgage where neither the principal nor interest is repaid. The interest is rolled up with the principal, increasing the debt each year.

These arrangements are variously called reverse mortgages, lifetime mortgages or equity release mortgages (referring to home equity), depending on the country. The loans are typically not repaid until the borrowers are deceased, hence the age restriction.

Through the Federal Housing Administration, the U.S. government insures reverse mortgages via a program called the HECM (Home Equity Conversion Mortgage). Unlike standard mortgages (where the entire loan amount is typically disbursed at the time of loan closing) the HECM program allows the homeowner to receive funds in a variety of ways: as a one time lump sum payment; as a monthly tenure payment which continues until the borrower dies or moves out of the house permanently; as a monthly payment over a defined period of time; or as a credit line.^[9]

For further details, see equity release.

Interest and partial principal

In the U.S. a partial amortization or balloon loan is one where the amount of monthly payments due are calculated (amortized) over a certain term, but the outstanding balance