How a mortgage works

The lender makes a payment to you allowing you to fund the purchase of a home. Each month you make a payment back to reduce the loan. Part of the payment is interest due to the lender, and part is capital and this reduces the amount that you owe. This is the reason they are referred to as capital and interest mortgages.

In the early years the borrower owes the lender a lot of money. This means that most of the payment is interest. Only a tiny amount will be capital that reduces the loan. Over time the amount owed will go down. This makes the interest due less. That results in more of each monthly payment being capital that reduces the loan balance. In the last few months the vast majority is capital. Repaying the mortgage in this way keeps the payments the same over the term and avoids undue hardship in the early years.



Borrowing to buy a house makes economic sense. If inflation in the economy is maintained at the government’s target figure of 2% pa then every year, in real terms, your loan figure is reducing in real terms. Your income is likely to grow by slightly more then inflation. Assuming a £25,000 income at the start of a mortgage then after 20 years you would be earning £37,000 based on only 2% a year inflation. In the meantime your mortgage payments are based on the loan taken, less the amounts repaid.

If house prices increase by the same 2% each year then every year will see the home rise in value. A home bought for £110,000 after 20 years of 2% growth would be worth £163,000. Of course houses prices do not generally move in a straight line, but over time there has historically been growth.



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The conclusion is that for house buying the very long term nature of the deal means that the loan should reduce as payments are made, the house should grow in value, and the income used to finance the loan should also grow. That increasing gap between the loan and value will increase the equity in the property. Paying off the loan at the end of the term results in a mortgage free property.

Gary Andrews Financial Services is a trading style of Tom French & Associates Ltd Independent Financial Advisers authorised and regulated by the Financial Conduct Authority FRN 185513. Your home may be repossessed if you do not keep up repayments on your mortgage.

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