Changes In Interest Rates

Since mortgage rates go up and down from time to time, albeit less frequently than banks' base rates, one would expect that every borrower would be repeatedly having to change the amount of his monthly repayment. Whilst it is true that this can occur, especially with violent changes in interest rates, in many cases frequent alterations in the amounts of the repayments can be avoided.

When rates rise by a comparatively small step many borrowers are given the option of either appropriately increasing their repayments or of extending the term of the loan. It will readily be comprehended that if the instalment remains unchanged but the interest element included in it becomes higher, then the capital repayment element becomes lower. Thus the mortgage is being repaid more slowly.

In recent years some rises in rates have been so violent that were the repayment instalment not to be increased it would not even cover the interest on the loan, with the consequence that the outstanding loan would be increasing instead of decreasing. However, most borrowers increase their monthly payments rather than extend the life of their loans.

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When interest rates fall it is open to borrowers to reduce the monthly payment - especially where the fall is one from a historically very high level such as 15%. However, many borrowers, having accustomed themselves to budgeting for their mortgage repayments, may leave them unchanged, which will result in the mortgage being entirely repaid earlier than originally planned.

True interest rate

Interest on annuity loans is normally charged on what is known as an 'annual rest' basis, i.e. the interest in the first year is charged on the initial loan for the period up to the end of the society's financial year. In subsequent years interest is charged for the whole year on the debt outstanding at the beginning of the society's financial year.

The consequence of this is that a borrower is paying interest at the agreed rate on money he is not borrowing, for the amount of the outstanding debt at the beginning of any year is more than the average amount borrowed over the whole year. Unlike short-term personal bank loans, however, where the true interest rate works out at something like twice the flat rate, the result of yearly rests on a long-term loan is quite small. A 15% nominal rate represents a true rate of 16.2%.

Endowment-linked mortgages

There is an alternative to the traditional annuity mortgage, which is the endowment-linked mortgage. The main difference lies in the method of making repayment of the loan.

Under the annuity method the borrower makes gradual repayment of the borrowed capital every month during the term of the mortgage. Under the endowment method no capital repayment at all is made to the society, monthly payments being restricted to the interest. Since the amount of the loan does not decrease each month, the amount of interest paid remains unchanged, so long as the interest rate remains unchanged. Repayment of the loan is made in one sum at the end of the term, from the proceeds of an endowment policy on the life of the borrower for the same amount and term as the mortgage. So the borrower must pay a monthly premium on the endowment policy to the insurance company, in addition to the interest to the society.

The policy itself is charged to the building society as security

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for the borrowing and the society is willing to accept this because (a) if the borrower lives to the end of the term the entire mortgage will be repaid in one sum from the proceeds of the maturing policy, and (b) if the borrower should die in the meantime the mortgage will be repaid entirely from the policy claim proceeds.

The supporting endowment policy may be a full with-profits one, a non-profit one, or a low-cost with-profits policy (see Chapter 12). Specimen costings of three different ways of arranging a mortgage are shown in the table on page 98.

A repayment mortgage has one particular advantage over the alternative methods for a person whose budget for the first few years is very tight: the tax relief available during the early years on the interest element is as high as it is throughout the term by the endowment method, so his net monthly outgoing for the first year, for example, will be some £9 less than the average amount as shown in the above example, although it will become higher as the years pass.

A disadvantage of the endowment method is that, when interest rates rise, it is not possible for the term to be extended; the higher interest charge must be met in full.

Option mortgages

An 'option' mortgage is one where, instead of the interest payments being allowable for tax relief, the rate of interest actually paid to the society is lower than the normal rate by approximately the basic rate of tax. The difference is paid to the society by the government.

This arrangement is intended to ensure that as much benefit is given to a house buyer who cannot, by reason of the smallness of his taxable income, take full advantage of the tax relief available, as is given to a person with a higher taxable income.

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