Understanding The Two Main Types Of Mortgage Financing

By Author: Lucy Carter
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Taking out a mortgage entails borrowing an agreed sum of money from a building society or bank to finance the buying of your first home. You then pay back this capital loan plus the interest set by your lender over a set period of time.

The most important thing to understand is that there are two main types of mortgage. The following guide let's you understand this in simple terms, so you can be sure to choose the financing that best suits your lifestyle.

Repayment Mortgage - Capital & Interest

In the same way you repay your credit cards, opting for this type of mortgage means you will make monthly repayments on the capital loan you borrow plus the additional interest set by your loan provider that is based on the amount you owe. In this way every month you will chip away at the loan until the amount you borrowed is paid off in full.

Advantages

This kind of mortgage financing is straightforward - at the end of your agreed monthly repayment term the loan will be fully settled. Depending on the lender, in many cases you will not need to take out additional life insurance as mandatory. Often ...
... you will also be permitted to make lump sum payments and overpayments into your mortgage account to reduce your capital loan, which in turn reduces the interest amount.

Disadvantages

When shopping around for first time buyer mortgages of this type, it's important to find out what kind of early repayment penalties your loan provider will enforce if you want to pay off the loan before the agreed term. This is a crucial factor as you might in the future want to benefit from a remortgage which offers a better deal and if the penalty to switch loan providers is too high, you would not have the flexibility to do this. Another disadvantage is that if you choose not to take out life insurance and die before your mortgage is repaid, the loan will still be outstanding and your relatives might have to sell the property to settle it. Another issue to take into consideration is that most lenders initially calculate your repayments to cover the interest on your loan, so you will not start really making a dent in the capital amount you borrow for some time.

Interest Only Mortgage - ISA, Endowment, Pension

This type of mortgage financing entails your monthly repayments covering purely the interest on your loan rather than including the actual capital amount you borrow. The way this works is you will take out a 'repayment vehicle' in the form of an ISA, endowment or pension plan to pay the capital sum when it is due at the end of your mortgage term.

ISA's

ISA stands for 'Individual Savings Account'. It allows you to save your money tax free. There are many types of ISA and it can be complicated to understand which one is best for you, so unless you're really financially savvy it's a good idea to use a financial adviser for this option.

Endowments

With endowments you make fixed investment payments so that when your interest only mortgage term is finished you will have the funds to pay your capital loan. These fixed payments are calculated on the amount you borrow together with the length of mortgage you choose. Endowments also include life insurance so that in the event of untimely death your mortgage will be covered. The crucial factor however is to let the endowment mature, since if you cash it in early you could receive less than the amount you originally invested and would not have the funds to pay your capital debt.

Pension Plans

This option allows you to make your monthly repayments into a pension fund which is tax free. When these funds are released you will be able to pay off your capital loan in full plus draw a pension from the remainder of the fund amount. This option also comes with life insurance included and is a popular choice for the self employed. You're advised however to use a financial adviser to help you make sure that your pension plan will both cover your loan and contain sufficient cash for your golden years.

Interest Only Advantages

The advantages of interest only mortgages is that they're highly tax efficient and if the proceeds of your investments exceed the amount required to repay the mortgage, you'll receive a tidy lump sum in addition to paying off your home.

Interest Only Disadvantages

The danger with this type of financing is that if your repayment vehicle funds don't accrue to the amount of the capital loan you borrow you will have a huge debt to settle at the end of your mortgage term. For this reason it's essential to make sure your repayment vehicle is growing enough to meet the loan due date. If you find it's not, you can make up for the shortfall by either finding further investment plans or increasing your monthly payments into the policy fund.

The above guide helps you get to grips with the basics when shopping around for first time buyer mortgages. Once you decide whether repayment or interest only is best for you, you can start comparing the different package deals available on the marketplace. Above all, be sure to do your research to fully understand the costs involved.
Sean Raston is an economics student and expert in first time buyer mortgages.