Flexible payments

In the early 80’s, my company, Mortgage Systems Limited, was responsible for introducing the original concept of the low start, flexible repayment mortgage, a derivative of the unique index-linked mortgage.  The story for those interested is included in Annex A.

The essence of a flexible payment mortgage is the ability of borrowers to vary their payments, up and down, to suit changing circumstances.  Any unpaid interest is added to the loan.  If you have a repayment mortgage, you would probably like to repay the capital as fast as you can afford.  A flexible mortgage enables you to do this on an ad hoc basis, for example, using an occasional windfall to knock off some of the mortgage debt.  But more importantly, you can take back any earlier overpayments should you need to; perhaps to buy a new car, or to fund general living expenses.

In some cases, lenders might allow a repayment holiday when you pay nothing for a short period to perhaps help when you are between jobs or are ill and cannot work. 

There is now a growing list of lenders offering these basic facilities, all with differing terms.  If there are no additional administration charges made for over or under payments, the IRR will always work out the same.  If you overpay, you will save interest; if you underpay, the debt will grow with unpaid interest.  But the interest is charged at the same effective rate.

Variable income borrowers
If you are self-employed with a variable income expectancy, a flexi-payment mortgage may be suitable provided you understand the way the scheme operates and are prepared to spend a little time “managing” your mortgage account.

One would naturally expect the IRR for a flexible mortgage to be higher than a conventional mortgage, since it offers desirable extra features.  As before, the value of any such extras is put into context by comparing the IRR and NPV with an alternative product using the “Loan Comparator” spreadsheet.  There is also a “Flexible Mortgage” spreadsheet included as a generic example of what is possible.

Stabilising payments with a flexible mortgage
One attractive use of a flexible payment mortgage is as a D.I.Y. (Do-it-Yourself) fixed rate scheme.  Suppose your Flexible Mortgage variable interest rate was currently 7% pa, but you could actually afford to make monthly payments as if the rate was 7.2% pa.  You could then keep those payments “fixed”, and as long as the actual interest rate charged stayed below 7.2%, you could maintain fixed payments for as long as you like. But in the meantime, you would be repaying some capital, so accelerating the time when the mortgage finishes altogether.  Alternatively, you could use this “fat” to ensure no increase in your payment is necessary even when variable rates exceed 7.2% for a period.

You have effectively achieved the best of both worlds – a stabilised payment schedule but without paying for a formal fixed rate scheme and still profiting in full from rate drops.  And no early redemption fee.

The table below illustrates the first ten years of a typical interest-only flexible mortgage of £100,000 at variable interest rates, but assuming a stable payment of £600 per month - equivalent to 7.2% pa.  In practise the loan has fallen by about £3,000 in ten years.  If the rate was a genuine fixed rate of 7.2%, the debt would still have been £100,000, and there would have been an early redemption fee.

            And so on…

After year one, because of the overpayment, the minimum payment that you could pay if you wanted, is lower than the ‘normal’ payment (ie without a flexible facility), because you have built up some ‘fat’, which has reduced the capital owing, although the lender has agreed to your maximum debt being £100,000 throughout, until the last year.

If you have been overpaying like this for several years, there will be sufficient fat to cope with an interest rate change of more than 7.2% pa for a short period, as illustrated in years four, five and six.

It is up to you to choose the effective “payment” rate at which to stabilise your payments – the higher the rate, the less likely it is to change, and the quicker the loan is repaid.  The IRR is the same whatever schedule you choose, unless the lender makes additional charges for each change.

The graph below illustrates the whole twenty-five year term, showing how it is possible to reduce the payment at any time.  After ten years, the interest rate is assumed to increase somewhat, so necessitating a payment increase.

Without the flexible payment facility, the ‘normal’ monthly payment would fluctuate much more in line with actual interest rate movements, as can be seen with the dashed line on the graph below.

Incidentally, at the time of writing, lenders still differ on the ‘flexible’ features they allow.  The best ones allow you to borrow back overpayments at any time, allow payment holidays and account for daily interest.  There should be no additional fee for payment variations and you should be able to view statements and vary payments via the Internet.  Check before you commit.

In summary, a stabilised (but flexible) schedule is ideal for the conservative borrower but who’s knowledge is good enough to understand the implications:  it may also turn out to be better value-for-money than a fixed, capped or collared rate as there are no guarantees to be underwritten. Some lenders operate the stabilised repayment feature without the need to trigger a minimum payment. Instead they accept a flexible full redemption period or final amount owing: this is not expected to be significantly different to the normal period. In any event most mortgages terminate before their scheduled full term anyway by either a sale or a changed loan.

Increasing payments with a flexible mortgage

Most people could afford to pay more each month in the future than today.  “Today” is always more expensive than “tomorrow” – your partner has given up work, you have kids to feed, furniture to buy, HP to settle, family holidays to pay for and so on.  But the future gets easier.  The kids leave home, your spouse goes back to work, you get a pay rise, even if it just keeps pace with inflation, and the HP is paid off… so paying for a mortgage gets easier over time – until the divorce that is!

For those wanting to repay a loan as fast as they can afford, they probably have a capital repayment mortgage anyway, but with a flexible mortgage you can accelerate payments at any time.  So one schedule that might appeal is the increasing repayment mortgage.  If you increase your monthly repayments every twelve months by 5% per annum, a 25 year mortgage @ 7% pa could be paid off in just under fourteen years, saving you thousands of pounds in interest payments: the saving is about £42,000 for a £100,000 loan. 

Moreover, you are not committed to the excess payments.  You have the choice at any time to revert to a lower level of repayments, and you can re-borrow any surplus capital you had repaid earlier, although a few lenders do not allow this important facility, so it’s worth checking. 

In short, for borrowers who don’t mind spending some time on their financial affairs, the flexible payment concept is almost Utopia. 

The graph following illustrates a twenty-five year £100,000 loan at 7% per annum throughout, finishing at year fourteen with payments increasing by 5% per annum.