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Repayment / Interest Only
Investment Vehicles: Endowment /
Pension / ISA
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It is recommended that you do not solely act upon the guidance in this site but seek advice which can take account of your circumstances. Moneytomove does not offer advice on the different investments described below or any type of investment contract.
THERE ARE TWO BASIC TYPES OF MORTGAGE:
Repayment Mortgage - Also known as a "capital and interest" mortgage, monthly repayments pay off the interest and the loan principal over the duration of the mortgage.
Interest Only Mortgage - Monthly repayments pay off the mortgage, while an investment builds over the lifetime of the mortgage that should pay off the mortgage at maturity.
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Repayment Mortgage
With each monthly repayment made, the money is used to cover both the capital of the loan and the interest due on the capital. This will see a gradual reduction in your overall mortgage debt.
There are two types of repayment mortgage. The first sees the capital repaid in equal monthly instalments for the duration of the mortgage. The second type sees early repayments predominantly consist of interest. The latter repayment mortgage is the most common, so we shall focus on this when talking about repayment mortgages.
At the outset of the mortgage, the capital is at its highest level, and so the monthly interest is also at its highest. As the repayments lower the mortgage capital over time, the amount of interest charged falls (but not necessarily the rate of interest). This means that early repayments will be dominated by interest, but as the loan is slowly repaid, a greater percentage of each subsequent repayment goes towards paying off the capital.
An annual mortgage statement (sometimes quarterly) will give a breakdown of the interest charged and how much of the mortgage capital has been repaid. Unlike an interest only mortgage, your annual statement will show a falling level of capital owed.
The mortgage provider may insist that a life assurance policy is obtained, so in the untimely death of the borrower, the mortgage debt is repaid in full.
ADVANTAGES
- Certainty. Unlike an interest-only mortgage, which contains the inherent risk of an "investment vehicle", a repayment mortgage ensures that at mortgage completion, the balance has been paid off in full.
- Depending on your chosen mortgage products flexibility, lump sum payments and overpayments may be allowed, which would go towards both interest and outstanding mortgage capital borrowed.
- Although there is a strong case for life assurance, it is frequently not a requirement with this type of mortgage, and as such, provides some additional flexibility when deciding upon your repayment strategy.
DISADVANTAGES
- The flip-side of the low risk of a repayment mortgage is that you cannot benefit from a healthy economy. With an interest only mortgage, your investment vehicle may lead to gains from a booming stock market, and this would translate into mortgage savings. With a repayment mortgage, this cannot happen. However, a repayment mortgage protects against the downside of an investment-led approach.
- As the bulk of early repayments go towards interest, this can disadvantage individuals that frequently move house. Each move sees an initial high-interest repayment, and this can lead to a much smaller amount of capital repaid, as opposed to someone that stays at the same abode for an extended period of time.
- Although some individuals may prefer to take out a mortgage without life assurance, the death of the borrower may result in the need to sell the property to pay off the outstanding debt.
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Interest-Only Mortgage
With an interest-only mortgage, each monthly repayment is used to pay off the mortgage interest only. The repayments do not pay off the capital that is owed on the property. Lenders will usually prefer the borrower to put an "investment vehicle" in place, ensuring the accumulation of monies for payment at the end of the term, although dependent on circumstances, some mortgage providers will be prepared to let the borrower take out an interest-only mortgage without an investment that will repay the loan. After all, the property can be sold at the end of the term if the borrower is unable to repay the mortgage capital.
INVESTMENT VEHICLES
Alongside the interest repayment, the borrower will take out some kind of "investment vehicle". This may be an endowment policy, a pension plan or possibly an Individual Savings Account (ISA). The borrower pays money into this investment alongside the interest repayments, and as this investment builds over the lifetime of the policy, at maturity, it should pay off the mortgage capital.
The single biggest problem with this type of mortgage is the risk inherent in the investment vehicle. If the investment under-performs, then the investment may not be enough to pay off the outstanding capital at maturity. The flip-side, of course, is that the investment may perform better than expected and there would be a resultant windfall at maturity. If this is the case, then the policyholder gets to keep the balance after the mortgage has been repaid.
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Endowment Policies
The most popular investment vehicle for an interest-only mortgage is an endowment policy. These policies have received widespread negative press attention over the past few years, first for the miss-selling scandals of the late 1980s and more recently because of the troubling performance of life companies such as Equitable Life and Friends Provident over the past few years.
Endowment payments are invested by life companies into large funds, used to purchase shares and bonds. As the stock market faltered early this millennium, many policyholders saw the value of their policies fall. This has seen a fall in take-up of new endowment mortgage policies, as consumers have accepted the inherent risk involved in such policies. To counter this, many life companies have now shied away from share investments, opting for more stable investments such as bonds (although the lower risk translates into a lower return on investment).
Endowment policies include life assurance as standard, ensuring that the mortgage is paid in full in the event of the untimely death of the policyholder. Life companies will also offer life assurance on its own for all types of mortgage consumers, and at maturity, will often make a small payment to the policyholder.
Should you remortgage at any time, by switching your mortgage provider in favour of better terms offered by a competitor, the endowment can continue uninterrupted and be paid to the relevant financial institution upon maturity. However, as you are not repaying the mortgage capital in the fashion of a repayment mortgage, some individuals choose to gain short-term funds by "cashing in" (surrendering) their endowment. There are strong penalties attached to this, and in the early years of the policy, the surrender value is frequently less than the amount paid into the policy.
Advice should be sought prior to making any decision to surrender a policy. Moneytomove is not authorised to provide advice in relation to these investment areas.
It is also important to clarify the three major types of endowment policy:
Full With Profits Endowment
The endowment lasts for the same term as the loan and a sum is assured of equal value to the loan, thus guaranteeing full repayment of the mortgage from the beginning. Provided all premiums are paid, then upon maturity, the investment repays the loan and there will be a remainder (reversionary and terminal bonuses) that belongs to the borrower. However, this type of investment is very expensive, and is now quite rare.
Non Profit Endowment
Like the with profits endowment, the sum assured is equal to the value of the loan, effectively guaranteeing repayment of the mortgage. However, there is no bonus payment to the borrower on maturity, and these are also an expensive type of investment, it is rarely used.
Low Cost Endowment
This is the same as a With Profits endowment, however the sum assured is of a lower value than the loan. It is set at a level whereby, upon maturity, the reversionary and terminal bonuses will also go towards repaying the mortgage. This means that there is no guarantee of the investment vehicle paying off the mortgage, as there may be a shortfall with bonuses. However, assurance for the term of the mortgage starts at the full value of the loan and slowly falls over time. This assurance covers the difference between the value of the endowment and the loan, ensuring the full mortgage value is paid upon death of the borrower during the term.
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Individual Savings Account (ISA)
Although endowment policies are the most popular interest-only related investment vehicle, there are other options. Using an Individual Savings Account (ISA) provides a tax efficient vehicle for savings. However, an ISA has a cap on the amount that can be invested annually, so can only really be used to supplement an existing investment vehicle, or for particularly small mortgages. For some people facing a shortfall at maturity of their existing endowment policy, investing in an ISA as a secondary payment vehicle may make up this shortfall. To set up an ISA, as with all options, it is best to speak to an Independent Financial Adviser (IFA) before deciding on an investment strategy.
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Pension Policy
Some individuals will opt to link their mortgage capital repayment to a pension policy. They make monthly payments into a pension fund. When the pension finally is drawn upon, a lump sum is withdrawn from the fund to pay off the mortgage. The remaining balance is then used to provide a pension to the individual. Money owed on a mortgage that is repaid from a pension plan is typically tax-free. This option is particularly popular amongst the self-employed, but due to the complex nature of this financial product, it is again recommended that you speak to an IFA before making your decision.
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Moneytomove is a trading name of Moneytomove Ltd which is an Appointed Representative of Pink Home Loans. Pink Home Loans is a trading name of Advance Mortgage Funding Ltd which is authorised and regulated by the Financial Services Authority. FSA Reg No. 305008.
Registered office: Flat, 119 Portobello Rd, Notting Hill, London W11 2DY. Registered in England, Number: 5425034
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