Throughout our lives, we encounter successive questions about housing: rent or purchase? Central apartment or suburban house? Fixed or variable-rate mortgage? When we've managed to save some money, a new question arises: should we repay the mortgage through a reduced repay payment or shorten the amortisation term?
Don't worry, because at UCI Mortgages, we provide you with the keys to know when it's more convenient to reduce your monthly repay payment and when to decrease the number of years dedicated to paying off the loan.
What's the Difference Between Repaying by Repay Payment or Amortisation Term?
The first thing you should know is that you are constantly repaying a mortgage: every time you make a payment, you are doing so. However, you also have the option of making a partial early repayment, meaning you can advance the payment of part of the debt to the credit institution.
In these cases, the 'To be or not to be' moment of every mortgage holder arises: should I lower the monthly repay payment or shorten the amortisation term? The implications, depending on your choice, are not the same:
• If you reduce the monthly amount, you'll have to deal with a lower installment, but the total interest savings will be less, and the repayment term remains the same.
• If you shorten the repayment term, you'll continue to pay the same amount each month, but you'll finish paying off your debt with the institution sooner and pay less interest in the long run for the same property.
To illustrate the difference between these two alternatives for early mortgage amortisation more clearly, let's explain with an example. Let's say you've just signed a mortgage in Spain for €150,000 over 30 years, with a variable interest rate of Euribor + 1% (currently 0.819%). This means you have a debt of €150,000 with the financial institution, plus another €19,232 in interest, which you'll pay - unless there are changes - in installments of €470 over 360 months.
However, you've come across an extra €10,000 (imagine you won the lottery) and want to allocate it to the mortgage. Here are the two possible scenarios:
• If you choose to reduce the term, you'll have €140,000 left to pay, plus €16,521.02 in interest, with a monthly installment of €470 for 334 months.
• Conversely, if you prefer to reduce the installment, it will drop to €438.75, but the term remains at 360 months, and you'll still have to pay €140,000, plus €17,950.26, nearly €1,430 more than in the previous scenario.
What to Consider When Amortizing a Mortgage?
As we've seen, when you repay a mortgage by shortening the term, the savings compared to the final price of the house (the loan plus interest) are greater than if you lower the repay payment. However, this doesn't always make term repayment the best choice.
What factors do you need to consider when choosing one option over the other?
• Current Financial Situation: The first aspect to consider is your current financial situation. Can you comfortably afford the mortgage installment? If it's challenging for you to make the payments, the best option is to lower the installment, reducing the monthly burden and increasing your savings capacity. In the example above, that initial €10,000 amortisation has resulted in a monthly saving of €31, which you can use as you wish. On the other hand, if you have a reasonable monthly installment relative to your income and can comfortably pay it, it's in your interest to reduce the term. In the final calculation, you'll pay less interest, making the property, for now, €1,430 cheaper, following the previous scenario.
• Medium- to Long-Term Plans: It's also essential to be forward-thinking. For example, you might currently be paying the installment without issues, but you also plan to start a family soon. When that happens, you'll need a higher savings capacity to cover the expenses that come with a baby. Maybe your goal is to pay off the mortgage sooner because you want to acquire a second beachfront property. In that case, shortening the term makes sense.
• Interest Rate: Related to the previous points, another parameter to consider when amortising a mortgage early is the forecast for the interest rate's evolution. It's important to analyze whether the reference rate will increase and determine how much you can afford to pay monthly to decide between term or installment. This doesn't apply to fixed-rate mortgages, where these fluctuations have no effect.
• Mortgage Age: In Spain, the most common mortgage system is the French model, where you pay the majority of the interest in the initial years of the loan. For example, in the first month of the mentioned loan, of the €470, €102.38 goes toward interest, while €367.71 goes toward principal repayment. However, in the first month of the 30th year, you'd only pay €3.83 in interest, while €466.26 would be for principal. Therefore, the stage of your mortgage's life also determines which option is better: if you want to shorten the term, it's best to do so in the initial stage, as you'll reduce more interest. In contrast, doing it in the final years, when almost everything is principal, won't result in significant savings, so opting for a lower installment is better.
• Tax Deductions: Similarly, potential tax deductions you may be eligible for will influence whether it's more convenient to amortise the mortgage through installments or term. This is because, for mortgages signed before 2013, the regulations grant the taxpayer the right to deduct 15% on a maximum of €9,040 annually, which includes what you pay through the monthly installment. In our example, you pay €5,640 per year in installments (€470 * 12 months), so you have another €3,400 in margin for early repayment and deduction in your income tax return, maximizing the financial effort.
In conclusion, while it's true that, when analyzing the loan globally, reducing the term is more profitable because the interest savings are greater, there are several factors to evaluate to make the most suitable decision for each specific case.