What it means
Nearly every mortgage is repaid on an amortising basis, meaning each monthly payment covers the interest due for that month with the remainder reducing the outstanding balance. Early on the payment is mostly interest, and only in the later years does the balance fall quickly, which surprises borrowers who expect steady progress from day one.
Rates come in two broad shapes. A fixed rate holds the payment steady for an agreed period, while a variable or tracker rate moves with a benchmark, so the payment can rise or fall during the term.
For a business, the same machinery applies to commercial mortgages on premises, warehouses and investment property. Lenders size these against the rental income or trading profit the building supports, typically wanting that income to exceed the loan payments by a comfortable margin.
Two ratios decide most lending decisions. Loan to value compares the loan with the property's worth and drives the interest rate offered, while an affordability or coverage test compares the payment with income to check that the borrower can actually service it.
The important nuance is that a mortgage is a package rather than a single number. Arrangement fees, early repayment charges, the length of any fixed period and whether the term is 20 or 30 years can matter more to the total cost than a small difference in the headline rate.
In practice
Real-world examples.
Example
A dental practice buys its own surgery for $900,000 with a $270,000 deposit and a $630,000 commercial mortgage over 15 years. The monthly payment is close to what the partners had been paying in rent, but at the end of the term the practice owns the building outright.
Example
A family remortgages from a fixed rate that has expired onto a new five year fix. Because their balance has fallen and the house has risen in value, their loan to value drops from 85% to 62%, which moves them into a cheaper rate band and reduces the payment by about $180 a month.
Example
A property investor with six buy to let mortgages sees rates rise on the two that are on tracker deals. Rental income still covers the payments, but the coverage ratio falls from 1.6 to 1.15, so the lender declines a seventh loan until one of the others is refinanced.
Think of it
“Mortgage is a home loan-secured by the property itself.
Formula
Calculation
Monthly payment = P x r x (1 + r)^n / ((1 + r)^n - 1), where P is the amount borrowed, r is the monthly interest rate and n is the number of monthly payments.
A buyer borrows $400,000 over 30 years at a 6% annual rate. The monthly rate r = 0.06 / 12 = 0.005 and n = 30 x 12 = 360 payments. Working the formula through, (1.005)^360 = 6.0226, so the payment = $400,000 x 0.005 x 6.0226 / (6.0226 - 1) = $12,045.15 / 5.0226 = $2,398.20 a month.
Look at where the first payment goes. Interest for month one = $400,000 x 0.005 = $2,000, leaving only $2,398.20 - $2,000 = $398.20 to reduce the balance. Across the full term the borrower pays 360 x $2,398.20 = $863,352, of which $463,352 is interest, which is why overpaying early has such a large effect.Case study
Seen in the real world.
This is an illustrative and entirely fictional example. Marlowe Bakehouse, an invented chain of four bakeries, had always rented its production unit and faced a rent review every three years that consistently pushed costs up. When the landlord offered to sell the freehold for $1.2 million, the owners had to weigh a $960,000 mortgage against the flexibility of renting.
The fictional finance adviser modelled both paths over fifteen years. Renting looked cheaper for the first four years, but the mortgage payment was fixed while the rent was assumed to rise, and by year seven the owned option was clearly ahead even before any gain in the building's value.
Marlowe went ahead, but with one condition the adviser insisted on: a facility that allowed 10% overpayments each year without penalty. Two strong trading years let the bakery overpay $150,000 in total, cutting nearly four years off the term.
Watch out
Common mistakes.
- Comparing mortgages on the headline rate alone and ignoring fees, early repayment charges and the length of the fixed period.
- Assuming the balance falls evenly over the term, when in the early years almost all of the payment is interest.
- Stretching the term to make the monthly payment affordable without noticing how much extra interest that adds over the life of the loan.
Questions
People also ask.
Does a longer term always cost more?
In total interest, yes, because the balance is outstanding for longer, though the lower monthly payment can be the right trade for cash flow reasons.
What actually happens if payments are missed?
Lenders normally work through arrears arrangements first, and repossession is a last resort, but the missed payments damage the borrower's credit record for years.
Is a commercial mortgage very different from a residential one?
The mechanics are similar, but terms are usually shorter, deposits larger and pricing is driven by the income the property produces rather than a salary.
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