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Each monthly payment under this system consists of both capital and interest. The proportion of each will alter as time goes by, the capital part getting larger and the interest part getting smaller. The result is that the amount owing gradually reduces.
It is normal to protect the loan against the death of one or more of the borrowers by means of a mortgage protection policy. This policy offers a reducing life cover, more or less keeping pace with the reducing loan amount and it is cheaper than the standard level cover policies. To ensure that the loan is paid off in the event of a critical illness it is also prudent to arrange suitable cover in this area and this can be provided also on a reducing basis.
Repayment mortgages are suitable for most people, particularly those who are likely to remain in their property for a considerable time. Steady repayment of capital by in this way helps to avoid a negative equity situation.
In this system no capital is repaid to the lender except on the mortgage termination date. Instead, a savings policy (which can be an endowment policy, a pension plan or an ISA savings scheme) is set up, the premium for which is calculated so that the policy can repay the loan on termination day or on prior death of the policyholder.
Provided investment returns exceed the assumed rates over the term of the policy, then the mortgage will be repaid and, indeed, there may be a surplus. However, repayment of the loan is not guaranteed, except if the policyholder dies.
The various types of interest-only mortgage savings vehicles:
Endowment - Most endowment policies today are of the unit-linked variety, and these have a substantial element of flexibility compared to the older with-profits types. They enable the insurance company to monitor the performance of the policy and to alert the policyholder if the fund growth is not ‘on track’. Thus, amendments to the premiums can be made in good time to ensure the timely repayment of the mortgage even in adverse investment conditions.
Endowment policies can make good investment vehicles, but not if surrendered in their early years when the returns can be less than the money invested. They can be relatively inflexible as mortgage repayment plans because, once started, they should be kept going in order to produce the best results.
For an endowment to be a suitable investment, the returns, after charges, must be equal to or greater than the cost of borrowing the money. Endowment mortgages are more suitable for those prepared to accept a certain amount of risk and who are likely to want to move often. The sum owing to the lender does not decrease as time goes by, and this has resulted in a negative equity situation for some borrowers in the past.
See also Endowment Policies.
Pension - A pension mortgage is set up in the same way as an endowment mortgage; during the term of the mortgage only the interest is paid to the lender. The outstanding loan is paid by a lump sum at the end having been accumulated by instalments in a pension plan. Depending on the type of plan, some or all the fund may be taken as tax-free cash on maturity and this is given to the lender to redeem the mortgage. The contributions into the pension scheme are given tax relief and thus it is possible effectively to obtain a large measure of relief on the capital element of your mortgage as well as on the allowable interest element. Furthermore, in the right circumstances the pension contributions could be paid by your employer rather than by you from your taxed income.
This makes the pension linked mortgage highly attractive
The negative aspects of a pension mortgage are:
Although it is possible to use them, occupational pension schemes such as the NHS or Teachers’ do not lend themselves for use as repayment vehicles, and of course, there would be a reduction in the total benefits from the scheme if it were used in this way.
ISA - This type of mortgage is similar to the endowment and pension mortgages as there is no repayment of capital during the mortgage term, only at the end. However, the savings vehicle is an ISA (Individual Savings Account). ISAs are ‘shell’ arrangements inside which are held shares, unit trusts or cash, and the initial value of which is limited.
ISAs are not subject to capital gains tax, nor most of the dividends from them to income tax, and can be very flexible. Savings plans can be stopped and started without penalty and there is no requirement for a particular level of income relative to the payments (unlike pensions). Also, having the life cover separate from the savings vehicle means that one can be altered without the other, if necessary.
However, ISAs should be regarded as a more risky repayment vehicle than the other options, although this will depend largely on where the funds are actually invested. Like the other interest only repayment options, borrowers will hope that investment growth over the mortgage term will be greater than the cost of borrowing the money.
The ISA mortgage has many advantages over other forms of mortgage repayment. For example, an ISA is available as a source of income for those who fall on hard times during the course of their mortgage, and can be temporarily discontinued if necessary.
Choosing your repayment method
Your choice will depend on the level of risk you wish to accept. You could, of course, combine different repayment methods in one mortgage. All the monthly costs (apart from the life assurance) can be reduced if the term of the mortgage is lengthened.
None of the repayment methods, other than capital repayment, guarantees to repay your mortgage (except on death or on the occurrence of a critical illness if such cover is part of the package). However, the ISA mortgage is the most flexible and can adapt well to many changes in your circumstances.
Mortgage indemnity premium
Borrowers who want loans of more than 75% of the property value are sometimes charged a one-off mortgage indemnity premium (MIP). It will vary according to the actual amount borrowed.
MIPs can be several hundred pounds, so it pays to keep the loan amount as low as possible, preferably below 75%. The MIP is charged to ensure that, should the borrower default and the property be repossessed, the lender will be able to recoup any shortfall in the loan if property prices have fallen in the meantime. However, in recent months more and more lenders are offering loans without requiring a MIP.
In the case of remortgages (or, indeed, any new loan relating to a house purchase) borrowers may find that they will have to wait longer before they become eligible for state support if they become unemployed or ill than if they kept their original loan. It is important to recognise the implications of this before moving away from a loan where better state benefits may be provided.
You may also have to pay the following fees, depending on the circumstances.
Solicitor's fee, searches, lender's booking or administration fee, valuation fee, intermediary's fee, or previous lender's reference fee.
In order to process mortgage applications, the lender will require detailed information on some aspects of your financial affairs, together with supporting documents (bank statements, proof of address, etc.).
You should ensure that you will be able, as far as you can see, to maintain the payments on your property, even when interest rates rise or (if the loan is for a let property) tenants are not forthcoming.
You should ensure that you have adequate life and critical illness cover to repay the loan if you should become ill or die, and also to consider payment protection insurance in case you lose your job or earnings for a significant period.
© John Bramwell 2005
BV Services is Authorised and Regulated by the Financial Services Authority
Get your finances
in good shape!
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