Basic Mortgage Definitions
What is a repayment mortgage?
A repayment mortgage is one where the monthly payments you make to a lender consist of interest plus a partial repayment of capital. The monthly payment is calculated so that, assuming the interest rate doesn't change throughout the mortgage term, you would pay exactly the same amount every month during the mortgage term. This repayment mortgage can be for anything from five years up to, in some cases, as long as fifty years.
What is an interest-only mortgage?
An interest-only mortgage is simply a mortgage whereby your monthly payment to the lender consists just of the interest, so there's no payment included to repay the capital. Therefore, you need a repayment plan to pay that capital back in some other way, which could be in ad hoc monthly amounts, occasional monthly amounts or in one lump sum at the end of the mortgage. It is important that you have a repayment plan to pay your mortgage back at some stage, as well as having an interest-only mortgage.
Is it better to have a repayment mortgage or an interest-only mortgage?
It really depends on your circumstances as to whether an interest-only mortgage or a repayment mortgage is better. Provided you can afford it, a repayment mortgage will, in most cases, be the best solution because it's the only guaranteed way of paying your mortgage back at the end of the term, providing you make all the monthly payments on time. However, for some people, an interest-only mortgage will make more sense. Perhaps because they expect to have significant increases in salary over the short-term, maybe they've just qualified and they've got other debts from university, so starting off with an interest-only mortgage for a few years can make sense. Likewise, some people will have a specific way of paying the mortgage back at the end of the term, such as from savings plans. So what people need to do is make sure they get advice on the options and choose the mortgage that's most appropriate for them. But they lowest-risk way of paying the mortgage back is to have the repayment mortgage.
What is an endowment mortgage?
An endowment mortgage is an interest only mortgage backed by an endowment policy which is designed as a lump sum to pay off the mortgage. Each month, in addition to making interest payments to the lender, you make a monthly contribution to an insurance company. That money goes into a fund which is mainly invested in the stock market and is designed to build up a lump sum so that at the end of the endowment term the mortgage is paid off. In addition to that, part of the money is used to provide life insurance and, possibly, disability insurance if you selected that option. This is so that if you die or suffer critical illness during the policy term, the lump sum is paid out from that stage so that you can pay off the mortgage. The actual returns from the endowment policy would depend on the stock market performance and how successful the investment manager has been. So it may, ultimately, produce more or less than it was originally designed to produce.
What are the pros and cons of an endowment mortgage?
The main pros on an endowment mortgage are that the investment may be sufficiently successful to mean that at the end of the mortgage term, the sum that the down payment possibly produces is in excess of what's required to pay off the mortgage, and therefore, you've got a bonus. On the contrary, the main disadvantage is that it may not produce a large enough sum, and that really is where the problems have come from endowment policies. A lot of the policies which were sold 15, 20 years ago are projecting now to produce less than the amount that they were designed to produce. And if that happens, people will end up with a shortfall, which they'll have to find from some other resource. There is an interesting correlation between why there is likely to be a shortfall and interest rates. And that is that, as interest rates have fallen, the investment returns have fallen. And hence the likely return from the endowment has fallen. But the quid pro quo for borrowers is that they have paid a lot less interest on their mortgage over that period. So although they've lost out on the endowment, they will have gained on the mortgage by paying this interest.
What are 'with profits endowments'?
With profits endowments' is designed to smooth out the peaks and troughs in investment. So you will make a regular monthly investment into your endowment policy, and the insurance company will invest that money into a variety of different investments: shares; gilt-edged securities (that's government stock); property; overseas shares; perhaps some cash. In the years when they make a good return, they will only declare part of that return as profits to you, and to compensate for that, in the years that they do badly, and perhaps make a loss, they will still declare a return. So, each year they declare a bonus, and that's added to your policy, and once added that cannot be taken away. At the end of the policy term, you will normally get a terminal bonus, and the amount of the terminal bonus would depend on the overall performance of the policy during the period you've had it. So, the main object of the 'with profits endowments' is to smooth out the peaks and the troughs, rather than you seeing the value of your endowment policy going up and down quite rapidly, in some cases, based on stock market values.
What are 'unit-linked endowments'?
A “unit-linked endowment” means that the money is directly invested into a stock exchange fund, which could be equities (iShares), it could be fixed-interest securities, such as government stock, or it could be property. You can choose the proportion that's invested in each type of share, or you can choose what's called a “managed fund”, which means that the insurance company fund managers will switch the investments between the different types of investment, depending on what they think is likely to generate the best return. With a unity-linked endowment, the value of the policy will go up and down directly each day with the value of the underlying securities. Some years it might fall in value, other years it might go up quite sharply. It will be relatively volatile compared to the with-profits policy.
What are ISA mortgages?
ISA stands for Individual Savings Account, and an ISA mortgage is an interest-only mortgage backed by an ISA. I.e., each month, you pay a regular monthly amount to your lender to cover the interest payments and you pay into a fund manager, whichever one you've selected, to build up a fund in your ISA so that at the end of the mortgage term you expect to have enough money to pay off the mortgage. The maximum amount you can invest in an ISA is 7,000 pounds a year. And although you can do that on an annual basis, with a mortgage most people would pay an amount monthly. If the mortgage is in joint names then both people can pay 7,000 pounds a year into an ISA. What that does mean is that it's not suitable for very large mortgages because you won't be able to pay enough into the ISA to pay the mortgage off. But it will be suitable for most people if they're prepared to accept the stock exchange risk that comes with stock market investment.
What are the pros and cons of ISA mortgages?
The main pro with ISA mortgages is that if the investments in your ISA do well, then the amount received by you when you cash in the ISA at the end of the term will be in excess of what's needed to pay off the mortgage, and so you've got a surplus. The main con is the exact opposite. If the performance of the investment is not up to what you expected, then you may not have enough to pay off the mortgage and you'll have to find some other way of paying off that shortfall. There's no specific term for an ISA. You can keep investing the money for as long as you want, so if the performance is not up to scratch, then you can simply keep the mortgage going for a bit longer and keep investing the ISA for a bit longer. Likewise, if the performance is good, you could choose to cash the ISA in earlier than you had originally intended, pay off the mortgage, and therefore pay less interest. So, the key thing, really, with an ISA mortgage is that you have to be prepared to accept stock market risks. If you get the investment right or, more particularly, if your fund manager chooses the right investments, then you can do very well, but it is more risky. Essentially, if the return on your ISA is in excess of the interest rate you're paying on the mortgage, then overall you'll have done well. If overall, the return is less, then actually you'll have done badly.
If I have an ISA mortgage, can I still have a cash ISA for my savings?
If you have an ISA mortgage, it will be a stocks and shares ISA. You cannot have a stocks and shares ISA and also have a mini cash ISA. So, if you want to store savings as money on deposit, as opposed to investments in the stock market, then you can't have an ISA mortgage as well as a cash ISA. You can't have a mini cash ISA along with a stocks and shares ISA.
What is a pension mortgage?
A pension mortgage is an interest earning mortgage backed by a pension plan. With a pension mortgage, you plan to use a tax-free lump sum, which you're allowed to take out of your pension plan, when you retire to pay off the mortgage. You'll be making a regular monthly payment of interest to your lender and putting regular payments, perhaps monthly or annually, into your pension plan. The calculation that is done by your advisor will show you how much you need to put into the pension in order to build up enough in the fund, so that the 25% that you can take out in cash tax-free is enough to pay off the mortgage. That's the theory. Obviously, in practice, the amount that your pension is worth would depend on how the investments perform.
What are the pros and cons of pension mortgages?
One of the biggest pros of a pension mortgage is that you get tax relief on all your investments into the pension fund and that tax relief is given at your top rate of tax. If you're paying 40% tax, then effectively the government is paying 40 percent towards your pension fund, and hence toward paying off your mortgage. In addition, if the investment in the pension fund does well, then the pension fund will produce an amount in excess of what's required to pay off the mortgage. Therefore, you've got a surplus which can be used for whatever purpose you like. If, on the other hand, the investment goes badly, you may end up with a shortfall, in which case you've got to fund that shortfall and the mortgage from some other resource. The age at which you can draw the pension fund will shortly be increased to 55. That's the earliest age. Most people won't draw the pension fund until they retire. Thus, one negative of the pension mortgage is that you can't pay the mortgage back until at least 55, and perhaps until you retire, and therefore you'll be committed to paying mortgage interest for longer than you may wish.
