As mentioned in the introduction, there are
two main methods of loan repayment: -
Capital repayment loans, where capital is repaid gradually
throughout the loan term as part of a regular payment.
They are also called annuity mortgages. The term re-payment is used to
signify a capital element is included.
where only interest is paid during the term, and the amount owing is settled at
the end with a lump sum, obtained from selling a separate asset, sometimes an
endowment policy or an ISA, or more often the house.
We will first look at capital repayment loans, and take as an example a typical £50,000 level repayment mortgage over 20 years, assuming 8% pa nominal interest compounding monthly. The complete repayment schedule is illustrated in Figure 5.
The monthly repayment is made up of two components; interest on the capital owing at the start of each period, and a capital repayment element, which reduces the amount owing.
In the early years, when little capital has been repaid, the monthly repayment mix is mostly interest. As time goes on, more capital has been repaid so the interest element reduces. There is then more of the monthly repayment available to repay capital. So capital is repaid faster and faster until it is all repaid and that’s the end of the mortgage – it has been amortised, or killed off.
that the interest and capital element shown are for the first month in
each year, because in practise the mix changes month by month.
Figure 6 graphically reflects the gentle convex curve of the capital owing over time. For longer terms it is flatter to start with since the capital element is smaller and so it pays off the loan more slowly. Figure 7 shows the year-by-year mix within each monthly repayment between capital and interest.