How borrowers can make the best of the `rest'

There are repayment mortgages - and there are repayment mortgages. The difference between them can mean up to five years longer to settle the loan and thousands of pounds more in interest payments. How? Well, it all depends on how you calculate the amount you pay back each month.

The issue has acquired greater significance given the gradual return to popularity of repayment mortgages. In essence, there are two main ways of meeting the cost of a loan. Most people still choose endowment mortgages, which involve interest-only monthly repayments on the loan. The capital itself is paid off by other means, usually through an endowment policy but also PEPs and the tax-free lump sum element of personal pensions. The shine of endowments has become tarnished by the realisation that they are highly inflexible and require long-term commitments. And warnings from endowment providers that they can no longer guarantee their policies will actually pay off the loan at maturity has led to a switch to repayment loans.

However, the manner in which the repayment is calculated is crucial. Typically, mortgage lenders will only calculate the amount of capital to be repaid at the end of a 12-month cycle, no matter how much has been repaid in the intervening period. This is known within the mortgage industry as the "annual rest" period. In effect, it means that borrowers are themselves lending money to their lenders throughout the year - except that their loans are interest-free.

The alternative is to credit part of the amount paid against the capital owed, as soon as it comes in, either monthly ("monthly rest") or daily ("daily rest").

A report last week by Yorkshire Bank, one of a handful of lenders that operates in that way, suggests that on an average pounds 51,000 loan, borrowers can end up over-paying pounds 13,000 or more if interest rates stay at 7.24 per cent. A borrower would take 21 years to pay off a same-sized loan if "daily rests" are applied instead of 25 years for "annual rests".

Despite the massive difference between the two methods of calculating how much is repaid on the loan, the vast majority of lenders refuse to switch to the one that is beneficial to borrowers. They argue that borrowers are always made fully aware of the methods lenders use when calculating repayments. Yet a survey by Harris Research for Yorkshire Bank suggests that a third of people have no idea when their mortgages will be fully paid off, and more than 50 per cent have no idea what their exact repayments are or how they are calculated.

Lenders who operate "annual rests" claim that a daily system would not help those in arrears, against whom interest would begin to build immediately if they failed to pay off their loans. Yet the vast majority of people are never in arrears and many of those who are will only be in that position for a few months. The benefits of daily interest credits far outweigh the potential penalties.

The lesson for borrowers is clear. If you are considering a repayment mortgage, look for a company that credits your payments daily or monthly. If you already have a variable-rate repayment mortgage, with no penalties for switching, do so right away. It could cut the cost of your loan by thousands of pounds. It would also give a kick in the teeth to the vast majority of lenders who abuse the public's trust in this way.

Lenders calculating mortgage interest on a daily basis: Birmingham Midshires, Britannia, Midland Bank, NatWest Mortgage Services, Portman, Royal Bank of Scotland, Woolwich, Yorkshire Bank, Yorkshire Building Society, TSB, Direct Line (Source MoneyFacts)