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To compare mortgages there are various factors to be taken into consideration. The main factors are:
- Changes in circumstances
- Early Repayment Charge
- Flexibility of repayment term
- Arrangement fees
- Overall APR
- Attitude to investment
- Term of mortgage / age of borrower
- Tax relief
Do you have any inappropriate prejudices or preferences toward the different types of mortgage rates available?. There will be occasions where, for example, adverse publicity or the 'advice' of friends leads you to a decision which could be inappropriate for your needs. Many people have been impressed by the idea of seeing the debt reducing each year, whereas others might have had a previous bad experience with a particular type of mortgage.
Affordability is always the major consideration. Clearly, the total monthly cost needs to be looked at, particularly with an interest only mortgage which will also have the additional cost of the capital repayment vehicle. Therefore attitude to future interest rate movements need to be considered as an increase in interest rates could make the loan unaffordable.
In terms of monthly cost in times of financial hardship, the capital and interest mortgage offers some flexibility. The lender will often be prepared to extend the loan term to keep repayments down, for example, at a time of increasing interest rates or recession. An interest only loan does not offer such flexibility because the basic monthly mortgage cost is the same, irrespective of term, as the interest is always paid on the total capital. The amount will vary according to prevailing interest rates.
How often do you envisage moving house in the future? If regular moves are predicted (progressing up the 'housing ladder') then an interest only loan may be more beneficial; the capital repayment vehicle can be transferred to the new property and used towards paying off the next loan. A small top-up contract (ISA or endowment ) can usually be arranged to tie in with the existing contract to provide repayment funds at the end of the mortgage.
In the early years of a repayment mortgage, very little capital is repaid and a borrower who moves home usually has to effect a new mortgage over another 25 years to keep the loan affordable. However, the premiums on the capital repayment vehicle of the interest only loan will remain at their original level, and hopefully still be on target to repay the original loan at the end of the term.
In respect of foreseeable changes in circumstances, one of the questions which may need to be addressed is whether you are likely to remain as residents in the UK or to emigrate. If the latter is a possibility then the capital and interest loan will probably prove to be more suitable. The long-term nature of endowment policies with their generally low surrender values in the early years makes them unsuitable.
When a loan is redeemed, there may be an additional charge made by the lender, depending on the type of mortgage. If the loan is at a normal variable rate, it is still common not to make an early repayment charge. On the other hand, fixed rate loans usually have a three or even a six months' interest penalty if the loan is redeemed at any time during the fixed term. Also, variable loans issued at discounted rates almost invariably carry an early repayment charge. Generally, the longer the initial term of the fixed rate, the larger will be the early repayment charge. The penalty is a one-off fee charged to the borrower.
Nowadays, it is common practice to waive any early repayment charge when an existing loan is transferred to the borrower's new property, especially where a fixed rate mortgage is involved. This retains the business for the lender and gives continuity to the borrower.
Flexibility of the repayment term is of little concern in the case of interest only mortgages, as it does not produce monthly cost savings. However, it is of particular concern when looking at capital and interest mortgages. For instance will you be charged a fee if the term is altered? What is the maximum term available? Is it restricted to your retirement age? Can the term be reduced if more rapid capital repayment is desired? If you get into financial trouble through working shorter hours or being temporarily laid-off, a sympathetic and flexible approach by the lender will be all important in helping overcome such short-term difficulties.
The size of the arrangement fee can vary considerably. Some lenders offer incentives, such as a refund of the arrangement fee on completion, or a fixed amount of, say, £499 or £995. Some lenders permit the arrangement fee to be added to the mortgage loan. This can be of considerable benefit to first time buyers when cash is limited. However, interest is then payable on the fee over the mortgage period. Some lenders allow, say, half of the fee to accompany the mortgage application, with the remainder being deducted from the completion monies.
Annual Percentage Rate (APR) is the total cost of borrowing which depends on the nominal rate of interest and on whether interest is charged annually, monthly, quarterly, daily or on some other basis.
The added costs and fees associated with arranging the loan are normally also built into the overall borrowing rate. The APR, therefore, is at a higher rate than the annual rate at which interest is actually charged on the loan. Comparison of the APRs of different providers is a facility for providing a direct and fair comparison of costs since the method of calculation is laid down in the Consumer Credit Act 1974. It is possible to compare the total amount payable by the end of the term. These are important comparisons if you are concerned about the total cost of the loan as well as the monthly outlay.
Which repayment method?
Your attitude to investment is of particular importance, bearing in mind that the selected repayment method has to repay the entire capital loan on maturity, or you will have to pay any shortfall from your own pocket.
With-profits policies are not guaranteed to repay any particular loan, unless a full with-profits endowment is chosen. A unit-linked policy offers even less guarantee. Many insurance companies now build in a policy reviews to check every so often that the policy is on track to repay the mortgage, in line with the latest available projections of maturity values.
The ISA on the other hand, is generally considered to offer a medium to high risk because of the investment assets held, usually containing a high exposure to UK shares. The long-term nature of the investment should even out some of the ups and downs of the market to produce a good long-term return. The ISA is very tax efficient and can be taken out as a series of annual payments or on a regular premium basis. An ISA will need the backing of a term assurance to provide adequate life cover, and the cost of that security must be taken into account.
With both unit-linked endowment and ISA options, the borrower needs to understand that there are absolutely no guarantees on return, growth being dependent on the success of the fund managers in a very changeable economic climate.
Cost is almost always the major consideration at outset. Endowment policies range from the most expensive, full with-profits endowment, to low cost endowments. Full with-profits policies guarantee repayment of the loan in full plus the chance of a healthy tax-free payment on top. Low cost endowments provide only a basic sum assured guaranteed on death, with a hope of additional payment if bonus rates hold up. The growth rates at which providers can project future benefits are laid down, and reviewed regularly, by regulators.
One of the important considerations to bear in mind in relation to a pension mortgage is that the premium always tends to be higher than the ISA or endowment comparisons, because only 25% of the projected fund at retirement is allowed to be taken as cash to repay the mortgage. Thus, 75% of the premium goes towards the provision of the actual pension. Whilst the actual overall proceeds are much higher than the alternatives, the cost along the way is correspondingly greater.
The term of the loan and your age are particularly important considerations when looking at pension mortgages as the policy is unable to provide any capital to repay the loan until at least age 50. For instance a first time buyer aged 22 would end up with a term of at least 28 years if the pension option was chosen.
Equally, an older borrower, looking to select the endowment option, would find it comparatively more expensive than the capital and interest loan because of the enhanced costs of the life cover related to the policy.
Whichever method of repayment is selected, the shorter the term, the more expensive will be the monthly cost. Pension and ISA contributions look more attractive over longer terms as the tax incentives have a compounding effect on the investment returns in the fund and will, therefore, generally become more competitive than the endowment options.
Portability is the ease with which a mortgage contract can be adapted to a change of the borrowers home. Generally, the endowment policy is the most portable; offers the possibility of increasing the policy without medical evidence on moving house; and can be maintained irrespective of the insured's occupation.
This last factor has a particular bearing on the pension option, where the borrower may, perhaps, change jobs and join an employer where there is an excellent staff pension scheme. He would have to make any existing personal pension 'paid up' to join the scheme, as it is illegal to build up benefits from both simultaneously. This makes the portability and continuity of a pension mortgage less attractive, especially for a younger client, where job mobility could be more important.
An ISA mortgage is less portable, simply because fewer lenders are prepared to accept ISA's as a satisfactory vehicle to repay the mortgage. Many lenders prefer to see an established track record of past performance. This method may well become more widely accepted in years to come, especially as most ISA's are linked to having long established unit trust funds provided by well-known companies. Nevertheless, the unit trust ISA is a risk investment.
Most people want to ensure that they maximize their tax relief to increase their spendable returns. In this respect, the maturity proceeds of an endowment policy, pension scheme or ISA are all tax free. However, that is where the similarity ends. Unlike pensions and ISA's, endowment policies will already have borne full tax within the life fund and the policy proceeds will reflect this additional cost. The only class of mortgage which currently offers additional tax concessions is the pension mortgage, where the premiums paid each year into the plan attract income tax relief at the payer's highest rate of tax. For a 40% taxpayer, this would bring down the net cost of a pension mortgage considerably, especially where the term assurance to cover the loan on death can be effected within a personal pension plan. An additional factor that could reduce the cost of this option even more would be for the borrower's employer to contribute to the plan. This would boost the retirement benefits and reduce the overall cost to the policyholder.