The
Building Society mortgage trap
One of the facts of life in the mortgage world is that mortgage repayments are nearly always collected monthly, no matter what the compounding frequency. Logically one would expect payments to be collected on the same day as the interest is compounded but tradition, emanating from the non-digital quill pen era of Building Societies, dictates a more bizarre arrangement. Many Building Societies, even today, collect monthly but compound annually.
Interestingly, this means that for a repayment mortgage, the true rate of interest is actually different every year. Like a flat rate loan, the fact that there is a capital element in your monthly payment is ignored until the year end. The higher the capital element, the greater the true interest rate.
This is dramatically illustrated in Figure 10, particularly in year 20, where a true rate of 15.5589% is the surprisingly large result from a nominal rate of just 8%.
The overall true rate will increase with shorter terms, as illustrated in Figure 11. The overall rate is the true rate taking all the monthly payments for the actual life of a mortgage rather than just for any one year.
If the number of rests per year (the compounding frequency) were the same as the number of collections per year, then the true rate would remain constant throughout as shown in the last column. The true rate for an interest-only loan is the same as for monthly rests – 8.3% in this example.
| Figure 10 A £50,000, 20 year repayment mortgage
@ 8% pa nominal interest, compounding annually, but collected monthly,
and showing the true rate each year.
Note the true rate increases to almost double the nominal rate in the last year. The reason for the difference is that capital is being repaid before interest accrues, but no credit is given. The later year’s repayments include a higher capital element and hence reflect a higher true rate. The overall true rate is 8.5125% pa if the mortgage is kept running for 20 years. |
The extra interest paid in this example is £1,479 more than for monthly rests at the same nominal rate. Why Building Societies continue with wacky arrangement is put down to “computer systems” but I suspect the extra profits made in the later years are not unwelcome, and most borrowers are quite unaware of this anomaly.
| Figure
11 A £50,000 repayment mortgage @ 8% pa
with monthly repayments: comparing
the overall true annual interest rate for different terms and
compounding frequency, or rests per annum.
|
Avoiding the trap
Note that this inconsistency only
affects capital repayment loans and not interest-only loans.
Moreover, just because lenders compound annually, or sometimes quarterly,
it does not mean they are necessarily poorer value for money.
The overall true rate may still be lower than that for a lender using
monthly rests. The problem is in
making the calculation, which is term dependent.
How can you avoid it? Firstly, if you want a repayment loan, particularly a short term one, favour lenders who compound at or below the collection frequency. In other words, a lender requiring monthly repayments should charge interest with monthly compounding or better. Commercial lenders often collect quarterly. Provided they compound quarterly or more often, there is not a problem but beware those that don’t. By beware, I mean ensure that the true rate is competitive for the term in question.
If you are already with a lender who compounds annually, try to repay the loan before the last few years when the true rate is at its highest. A switch to an interest-only loan would also result in a lower true rate. Alternatively, switch (re-mortgage) to another lender, with a competitive true rate, but who compounds monthly or better.
There are some benefits. If you are in arrears with an annual compounding lender, you may not have to pay interest on outstanding payments within the lender’s charging year. In theory you can default for eleven months and pay the entire years payment as a lump sum just before the year end, and still not pay any extra interest. Whether a lender will allow this or not is another matter.
Interest-only
loans
From the lenders standpoint these loans are
straightforward and there are none of the traps associated with the repayment
method. Suffice to say that the collection
frequency is the most relevant parameter. A
monthly interest-only payment implies the interest accrues monthly; the true
interest rate is then calculated the same way as with a repayment loan with
monthly rests. Indeed one can look
at an interest-only loan as a capital repayment loan where the term is infinity,
or at least a very large number.
In the 60’s and 70’s some Building Societies charged a higher nominal interest rate for endowment mortgages than for repayment mortgages, to compensate for the lower return achieved when capital was not repaid monthly. That is rare today but the anomaly still exists, when rests are annual, where for the same nominal rate, interest-only borrowers enjoy a lower true interest rate than that for repayment borrowers.
The key to the value-for-money measurement of an interest-only loan is the performance of the separate repayment vehicle and this is discussed in Part II, along with the reasoning behind choosing this method.