The most common way to repay a loan
is to make regular payments of the capital (also called principal)
and interest over a set term. 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.
No capital or interest
For older borrowers (typically in
retirement), it may be possible to arrange a mortgage where neither
the capital nor interest is repaid. The interest is rolled up with
the capital, increasing the debt each year.
These arrangements are variously
called reverse mortgages, lifetime mortgages or equity release
mortgages, depending on the country. The loans are typically not
repaid until the borrowers die, hence the age
restriction.
Interest only
The main alternative to capital and
interest mortgage is an interest only mortgage, where the capital
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.
