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Mortgage Repayment Options
Below are details of the most common repayment methods for both a Repayment (capital & interest) mortgage and an Interest Only mortgage.
- Repayment (Capital & Interest)
- Interest Only
Endowment Policies include life cover that will pay out a lump sum to repay the mortgage, should the life assured / borrower die during the mortgage.
Capital & Interest Repayment Mortgages
Capital and interest mortgages, also known as repayment mortgages, involve the borrowing of a sum of money over a chosen period, typically 25 years. The borrower makes a monthly payment to the lender, made up of interest charged on the amount borrowed and a capital repayment.
As the capital is gradually repaid each month, the outstanding debt is reduced. As a result, the interest content gradually reduces and the capital content increases as a proportion of the monthly payment. During the early years of a repayment mortgage, most of each month's payment is interest and it is only in later years that this is reversed. After 25 years, the loan is repaid in full. If interest rates rise, the monthly mortgage payment rises. If interest rates fall, the monthly cost reduces.
Interest Only Mortgages
In respect of interest only mortgages, the borrower agrees at
the outset of the mortgage that only the monthly mortgage interest
will be paid to the mortgage provider each month and that the
total capital borrowed will be repaid by the borrower at the
end of the term as a lump sum.
Since the capital is not repaid until the end of the term, the monthly interest cost is the same amount for the whole period of the loan if interest rates do not change. The repayment of the capital is usually funded by the maturity proceeds of an investment plan, such as an endowment policy, the tax-free cash sum of a pension, a unit trust savings plan such as an ISA.
The lender will sometimes require that the savings vehicle is assigned as extra security for the mortgage. However, the the majority of lenders no longer require this because of the administration costs involved in effecting assignments.
Endowments are life assurance policies which do not continue for the whole of one's life but come to an end on the maturity date or on the earlier death of the life assured.
The term between commencement and maturity date is a number of years chosen by the policyholder at outset. Almost any term is possible, provided that it is more than ten years and ends before the life assured reaches a given age, such as 65 or 75 years.
During this term, the policyholder pays a regular monthly or annual premium. The benefits of the policy will be paid if the life assured either survives to maturity date or dies earlier.
Endowment policies are the most expensive form of life assurance. Since they pay out on a given date or earlier death, they provide a savings plan capable of achieving the saver's goals whether the life assured lives or dies. They therefore need consideration for purposes such as paying off a mortgage.
Endowment policies can be provided in several different formats:
- as a full endowment policy with-profits
- as a low cost endowment with-profits
- as a unit linked endowment
Full endowment -With-profits
A full with-profits endowment provides a guaranteed sum assured equal to the initial loan both on death or on survival, irrespective of the investment returns in the market. Bonuses are added to the policy over the term, usually annually, as reversionary bonuses. These bonuses credited are over and above the amount needed for the mortgage repayment and so go back to the borrower as 'tax-free' cash. Thus, at maturity date or earlier death, the policyholder will receive the benefit of reversionary and, possibly, terminal bonuses in addition to the guaranteed sum assured.
How they work :
With-profits policies provide relatively high guaranteed sums assured. In each profitable year, part of the surplus on the with-profits fund is transferred to reserves to help to maintain the bonus rate in years when investment profits are not so good. For these reasons, the with-profits policy has less potential for high investment gains than a unit-linked endowment; but it has a higher level of security.
The policyholder chooses the guaranteed sum assured needed at maturity date, perhaps to pay off a mortgage. At maturity date, all the bonuses attached to the policy are surplus tax-free cash for the policyholder's own use. For these reasons, full with-profits endowment policies are expensive.
A low cost with-profits endowment is a combination of a with profits endowment and a decreasing term assurance in the same policy.
The objective of these policies is not to provide a large guaranteed sum assured plus bonuses at maturity date, but instead to use the bonuses to build up to the sum assured needed at maturity date.
Thus, if the sum assured required is £40,000, the initial with-profits endowment sum assured may be only £24,000. This costs only 60% of the cost of a £40,000 full with-profits endowment assurance, and is calculated as the figure that will grow to £40,000 by maturity date.
Alongside this with-profits element is a decreasing term assurance that starts with a sum assured of £16,000 and decreases in line with the bonus additions to the with-profit element. This combination provides £40,000 death benefit should the life assured die before maturity date. What is more, the bonus rate used to calculate the initial endowment sum assured is usually only about 80% of the current bonus rate. Thus, in the above example, if all goes according to plan there will be £40,000 plus some surplus bonus at maturity date. However, it is important to note that the amount paid at maturity date is not guaranteed and could be insufficient for the purpose for which it was originally designed. The payment at earlier death is fully guaranteed.
Unit-linked endowments .
Unit-linked endowment plans are regular contribution policies. The bulk of contributions is allocated to units, at their offer price, in investment funds of the planholder's choice. The planholder has a choice among general and specialist equity funds, property funds, fixed interest funds and managed funds. Each regular contribution swells the number of units attached to the plan. The objective is that the market value of each unit will increase over the longer term as a result of reinvested income from the underlying assets and capital growth in their market value.
As the market value of the assets fluctuates, so the unit prices will go up and down. For continuing plans, falling unit prices provide the added benefit of pound cost averaging. (The benefit of being able to buy more units with the regular investment than usual) When unit prices are low, the regular investment buys more units than it does when prices are high. Over the longer term, the average cost per unit to the investor is lower than the average unit price over the period, giving the investor a more favourable growth rate.
The benefits from these plans on death or maturity are the greater of the guaranteed sum assured or the cash value of the units at their bid price. Terms to maturity date are available from 10 to 25 or 35 years, with a maximum age at maturity date of, say, 65 or 70. Nowadays, most plans incorporate an extension option enabling the plan to be increased by ten years to meet the planholder's changing needs and to avoid having to take maturity benefits at an inappropriate time.
Pension mortgages involve the same mortgage costs and fees as endowment mortgages. However, the lender will almost certainly include more detailed conditions and precautions in the mortgage offer. In addition, there will be the cost of the pension policy premium. The pension policy must be of sufficient size for the tax-free lump sum available at retirement date to repay the mortgage.
The premium cost will therefore be significantly larger than that for an endowment policy, even after allowance for tax relief on the pension contribution. In addition, the borrower will need a level term assurance policy, possibly pension term assurance, to repay the mortgage in the event of early death.
A pension mortgage is the most expensive mortgage in terms of the monthly repayments required in spite of the favourable tax treatment of pension policies. However, this method also pays a residual pension from the date when the mortgage is redeemed.
One of the most common conditions attached to a pension mortgage is for the lender to restrict borrowing to, say, 80% of the pension policy's projected tax-free cash lump sum. This provides a margin of safety for the lender in terms of loan repayment.
The borrower also needs to ascertain whether there are any financial penalties involved in future switches from a pension mortgage to, say, a repayment or an endowment mortgage. This is a possibility as a person's situation may change over the term of the loan; for example, the borrower may become ineligible to continue pension contributions
(Personal equity plans - Now replaced by ISA's)
There are two forms of PEPs, a general and a single company. A general PEP can invest directly in the shares of UK and other European Union companies. Single company PEPs can invest in the shares of one UK or other European Union company only. PEPs could not be held in joint names but individual investors were each allowed to take out one general and one single company PEP in each fiscal year.
The major attraction of using PEP's as a repayment vehicle for mortgages was their special tax exemptions on the investment growth. Peps have not been available since 5 April 1999, when they were replaced by individual savings accounts (ISAs). However, PEP holders at that date still retain the full value and tax privileges of their existing Peps, in addition to their future entitlement to subscribe for ISAs.
Individual Savings Accounts (ISAs)
On 6 April 1999, ISAs replaced Peps as tax efficient savings vehicles. The Government hopes that the range of ISA providers will be large and that people will be able to invest in ISAs at, say, their local supermarket.
The limit on contributions into ISAs is £7,200 p.a. per person, of which up to £3,600 may be held in a cash ISA. However, as a concession for the over 50's, the maximum contribution in 2009/2010 will be £10,200, of which not more than £5,100 can be held as cash. This limit will become standard from 2010 /2011 for all OSA investors.
Investors may invest in a separate ISA for each form of investment or in one ISA packaging several forms of investment. ISA investments will be free from income tax and capital gains tax.