Repaying A Mortgage
There are two basic methods of repaying a mortgage - repayment or interest-only.
Repayment: guarantees the loan is paid off in full at the end of the agreed term, but you will need to arrange separate life cover. Click here
Interest-Only: You pay interest only to the lender throughout the loan and pay back none of the outstanding debt until the end of the term.
As well as your monthly payment into a separate investment or savings plan (endowment policy, personal pension or ISA), the proceeds of which are designed to pay off your loan. The value of the investment may be greater than the outstanding loan leaving a surplus lump sum However, you must remember that you could face a shortfall. Click here
Repayment
With a repayment-type mortgage, the amount you pay to your lender every month consists of interest owed on your loan, plus repayment of some of the capital itself. This makes for monthly payments that are slightly higher than with an interest-only loan. But it does bring the peace of mind of knowing that you are reducing your debt every month. And you are guaranteed to have paid off your debt by the end of the mortgage term. You will have to arrange your own life insurance with a repayment mortgage, in case you should die before the mortgage is paid off.
In today's cautious times, more and more new borrowers are taking out repayment-type mortgages.
Pros
Guaranteed to pay off your debt
Security of knowing debt is reducing monthly
Cons More expensive than an interest-only loan
Have to arrange your own life insurance
Interest-only
With an interest-only mortgage, your monthly repayments are made up
of three parts: interest on the capital you owe your lender; life insurance;
and a contribution to an investment plan designed to pay off the outstanding
capital at the end of the mortgage term.
An interest-only mortgage will generally work out slightly cheaper per
month than a repayment mortgage, but is inherently more risky - there
is no guarantee that the investment plan you choose will generate enough
capital to pay off the outstanding debt at the end of the mortgage term.
You'll have to rely on your investment provider informing you that your fund isn't doing well, and you'll have to bump up your contributions accordingly. On the other hand, if your investment is very successful, you may be able to pay off your debt and have a lump sum left over, or even clear the debt years in advance of the expected date. But don't count on it.
Endowment
Endowment Mortgages
An endowment mortgage is an interest-only deal. Every month you pay interest on the amount owed to your mortgage lender, and invest a sum with an insurance company in an endowment policy. The policy is designed to grow throughout the mortgage period into a sum to pay off your outstanding capital debt (which never reduces) at the end of the mortgage period. The hope is that, having paid off the capital, you will be left with an extra lump sum.
There is no guarantee of this however - you could be left with a shortfall. As a result, endowment policies have become less popular in recent years.
Surrendering endowment policies
People's financial circumstances can change - sometimes for the worse. Endowment policyholders can be tempted to cash them in when in need of extra money. This is rarely worth doing - and never before the policy has been held for nine years, because you are unlikely to get your money back. And it gets worse - you'll need to make an alternative arrangement to pay off your mortgage.
There are two types of endowment policy:
1. With profits endowment
Your monthly premiums are pooled with the funds of all the other investors. At the end of year, the life company will allocate bonuses to all the investors (depending on the investment performance). Once awarded, these annual or reversionary bonuses can't be taken away.
At the end of the term (when the mortgage is due to be repaid) the life company will pay a one-off terminal bonus. The terminal bonus may represent a large proportion of your final payout (50% or more), but isn't guaranteed.
2. Unit Linked Endowment
Your premiums buy specific units in stock market investments. The value of these units (like the stock market) can go up and down on a daily basis.
Unit-linked funds have the potential for greater and faster growth than the with-profits endowment (possibly leaving you with a tax free lump sum, or maybe the chance to pay off your mortgage early). However, there is also a greater risk that the unit linked policy may not produce such good returns as with a with-profits policy.
Pros
Could make more money than is needed to pay off the capital debt on your home
Could pay off your mortgage early built-in life cover
Cons
Could be left with a shortfall
Inflexible - can't stop and start contributions
ISA
An ISA (Individual Savings Account) is a form of investment that enjoys
considerable tax benefits - growth is tax-free. So if the plan performs
well you could be left with a considerable surplus after the mortgage
has been repaid, or you may be able to pay off the loan several years
in advance of the expected date.
There are some 'packaged' ISA mortgages, where the plan includes built-in
life or term assurance. Otherwise, if you select an ISA to repay your
home loan, you may have to arrange life cover.
Pros
Tax Free investment
Possible surplus lump sum
Possible early repayment
Cons
Separate life cover may need to be arranged
Tax-free benefits not guaranteed
No guarantee the loan will be repaid.
Pension
It is possible to use some of the proceeds of a personal pension plan
to repay a mortgage. Since personal pensions have built-in tax benefits,
there is the potential for a greater return than from an endowment policy.
But you should remember that your pension is designed to provide an
income during your retirement years, and there are strict limits as
to the amount of money that can be taken as a tax-free lump sum - a
maximum of 25 % of the plan's value.
You must consider whether it makes sense to use a sizable portion of your hard-earned savings to clear your mortgage. You may need to arrange separate life assurance cover.
Pros
Built in life cover
Tax-Efficient investment
Cons
Uses valuable retirement funds
Cannot access money until you are 50
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