Types of loan

Loans are of two fundamental types, namely repayment mortgages and interest-only mortgages. A repayment mortgage requires payments of capital throughout the term, whereas an interest-only loan is arranged on the basis that the whole of the capital is repaid only at the end of the term, or on the death of the borrower.

Interest only
An interest-only loan requires a means of building up sufficient capital to repay the loan, normally an investment scheme of some kind such as an endowment or an ISA.

To be advantageous, the investment vehicle will have to produce an investment return greater than the interest paid on the mortgage and any tax liability that arises on the investment.

With an interest-only mortgage backed by an investment vehicle, strong investment performance may lead to a surplus which would be available to the borrower at the end of the term. However, it is also possible that relatively poor performance could mean that the amount available from the investment will be insufficient to pay off the mortgage.

Repayment mortgages
Repayment mortgages are often referred to as annuity mortgages and each monthly repayment is composed of part capital and part interest. Repayments may be level or increasing.

These mortgages can be divided into two types, constant net repayment mortgages and gross profile mortgages.

Constant net repayment mortgages
Constant net repayment mortgages are the most usual type of repayment mortgage. If interest rates remain static, a constant amount is paid throughout the entire mortgage term. Constant net repayment mortgages are offered by the large majority of building societies, although not generally by banks.

Gross profile mortgages
Using a gross profile mortgage, loan repayments are calculated on the basis that, if interest rates remain static, constant gross payments are made each year. Consequently, as more interest is included in the payments in the early years than in the later years of the mortgage term, the net amount payable will gradually rise throughout. The initial payments will be lower than with the constant net repayment mortgages, but greater in total over the entire mortgage term.

As a result, a gross profile mortgage is usually more attractive to a first-time buyer who has no surplus funds, with a constant net repayment mortgage often being more suitable for a person already established in the property market.

Features of repayment mortgages
It is fairly easy to amend a repayment mortgage, e.g. by extending the term or deferring repayments. Provided repayments are made on time, this type of mortgage provides the borrower with the certainty that the loan will be repaid at the end of the term.

In general, the cost of a repayment mortgage is less than the cost of an interest-only mortgage if the associated investment vehicle is taken into account. The repayment method therefore provides the cheapest option for most borrowers. However, there is no possibility of a surplus, although it is guaranteed to finish at a set time and is thus far safer.

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