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.
Year |
Actual |
‘Normal’ |
Minimum |
Actual |
Debt |
1 |
7.00 |
£583.33 |
£583.33 |
£600 |
£99,793 |
2 |
6.00 |
£500.00 |
£482.22 |
£600 |
£98,547 |
3 |
5.00 |
£416.67 |
£292.29 |
£600 |
£96,222 |
4 |
9.00 |
£750.00 |
£419.58 |
£600 |
£97,743 |
5 |
8.50 |
£708.33 |
£511.51 |
£600 |
£98,896 |
6 |
8.00 |
£666.67 |
£570.62 |
£600 |
£99,634 |
7 |
7.00 |
£583.33 |
£551.68 |
£600 |
£99,401 |
8 |
7.00 |
£583.33 |
£531.52 |
£600 |
£99,151 |
9 |
6.00 |
£500.00 |
£426.96 |
£600 |
£97,865 |
10 |
6.50 |
£541.67 |
£357.46 |
£600 |
£97,001 |
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.