One of the essential elements in the negotiation of a home loan is the delay allowed for repayment of the capital, i.e. the duration. In general terms, one may say that the longer the duration of a home loan the lower the amount of each repayment instalment, which gives the borrower more breathing space; all this, however, means paying overall a larger amount in interest, precisely because the capital is repaid more slowly. The practice also is that a longer duration means increased interest instalments to compensate the bank for its greater risk.
Repayment of the amount of the mortgage, then, takes place according to the terms fixed by the parties: the sum of these agreements makes up the redemption plan or amortization plan (or repayment plan).
Adequate information/understanding about the redemption plan is indispensable for the borrower so he can assess effectively his own capacity to repay, make a prudent plan for his future positive and negative cash-flow, and choose the repayment method that best suits his requirements.
Furthermore, by breaking down the elements that go to make up each instalment (capital and interest), the redemption plan also serves to identify the financial burden of interest to be shown on a company's books or the extent to which mortgage payments on the purchase of a primary residence may be tax deductible.
Close evaluation of the redemption plan is also useful with a view to any early discharge of the home loan, and the payment, if necessary, of the relevant penalty: depending on the plan agreed, half way through the duration of the home loan, more or less than half of the capital may have been repaid (in “French-style” mortgages, generally less).
The most commonly used repayment plan is the one usually referred to as “French-style”; the instalments, determined according to a precise, balanced financial formula, are initially composed of more interest than capital, while as time goes on, the proportions tend to become inverted.
When the chosen interest rate is a fixed rate, the repayment plan set at the time of the contract remains unchanged for the whole duration; if instead the rate is variable, the fluctuations are reflected in the repayment plan, so the redemption plan illustrated at the time the contract is signed is only indicative.
The payment deadlines may also be set differently: so instalments may be monthly or quarterly, six-monthly, etc. The more frequent the instalments are (e.g. monthly), the more quickly the capital is repaid: that means that the borrower will pay, in absolute terms, less interest. From another point of view, however, since the borrower pays out the money earlier, the effective rate of interest stipulated increases: let us take the following three examples of a theoretical home loan of Euro 100,000.00, for a term of ten years at a nominal rate of 10% (excluding other expenses), using the classic “French-style” amortization:
a) annual instalments:
- amount of each instalment: Euro 16,275.00;
- total amount to be repaid: Euro 162,750.00;
- amount of interest: Euro 62,750.00;
- I.S.C. or summary cost index (= T.A.E.G. = effective overall annual rate): 10%;
b) six-monthly instalments:
- amount of each instalment: euro 8.024,00;
- total amount to be repaid: Euro 160,480.00;
- amount of interest: Euro 60,480.00;
- I.S.C. or summary cost index (= T.A.E.G. = effective overall annual rate): 10.25%;
c) monthly instalments:
- amount of each instalment: Euro 1,322.00;
- total amount to be repaid: Euro 158,640.00;
- amount of interest: Euro 58,640.00;
- I.S.C. or summary cost index (= T.A.E.G. = effective overall annual rate): 10.47%.
This shows the importance for the borrower of carefully evaluating all aspects of the contract so as to optimise the results obtained.
Recently, financial markets have been proposing a series of products, called flexible mortgage loans, to try to meet the particular requirements of borrowers.
The following are a few examples:
a) Pre-amortization mortgages are those that allow for an initial period (which may be very brief and merely due to technical reasons; or even of several years' duration) during which the borrower pays only interest, putting off the start of regular repayments of capital. The consequence is that the first instalments (composed solely of interest) are particularly low, while the subsequent ones (including capital as well) are particularly high. The absolute cost of the home loan also rises because of the slow repayment of the capital;
b) A variation on the above, but with similar effects, is an arrangement whereby only a part of the capital is amortized from the beginning and at the end there is a maxi-instalment including the part of the capital whose repayment has been delayed, which may vary between a minimum proportion (e.g. 25%) and maximum proportion (e.g. 50%) of the capital provided;
c) Maximum flexibility is provided by a home loan where the repayment of the capital is left to the discretion of the borrower; in such cases the instalments are made up only of interest, while the capital may be repaid freely, usually within a pre-ordained grid: e.g. 15% by the end of the 5th year, 20% by the end of the 10th year, 30% by the end of the 15th year and 35% by the end of the 20th year (or: at least 15% by the end of the 7th year, at least 40% by the end of the 14th year and the remaining 60% by the end of the 20th year), and so on. Apart from the need for greater planning ability that such mortgages require of the borrower, it is evident that while on the one hand there may be a strong temptation to put off as long as possible the repayment of the capital, on the other that has a cost in terms of the payment of a greater sum in interest.