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Mortgage Repayment Methods

Choosing how to repay your Mortgage

The two basic options available to you are:

  • Repayment Mortgage
  • Interest only mortgage

Repayment Mortgages

where you repay to the lender on a monthly basis a mixture of capital and interest from day one and where the amount of loan outstanding gradually reduces over the term.

Capital and Interest mortgages as they are sometimes known have certain advantages, namely:

  • The debt will reduce with each monthly payment you make, albeit that the reduction will be gradual in the early years.
  • As the debt reduces the amount of capital repaid increases, thus increasing your equity in the property.
  • Making payments in full as they fall due guarantees that the mortgage will be repaid in full at the end of the term.

Given the advantages listed above you will understand that repayment mortgages tend to be more suitable for cautious individuals and for shorter-term mortgages (generally 15 years or less). Stock market based investment products such as Endowments, Individual Savings Accounts (ISA's) and Personal Pensions can be rewarding if the average performance of the underlying investments over the mortgage term (net of charges and tax) exceeds the average mortgage interest rate payable. It must be remembered that investment-backed plans do not guarantee to repay your mortgage at the end of the term.

Interest-only Mortgages

Each monthly payment to the lender consists only of the interest on the loan with no element of ongoing repayment of capital. You will need to consider how you will pay the loan back at the end of the mortgage term by possibly using an investment product such as an endowment, pension, individual savings account.

Endowment Mortgage
If an endowment mortgage is used, along with the interest payments on the loan, the borrower pays the premiums on an endowment policy with a life assurance company. Assuming that the plan achieves at least the annual growth rate assumed at outset, then the endowment will mature on the given date to repay the mortgage. The level of premium is fixed at outset. Should the annual growth rate achieved be less than that originally assumed then an additional ‘top-up’ policy will need to be effected, or the shortfall met by other alternative funding or switching the shortfall onto repayment basis. However if the your fund grows faster than predicted then it may be possible for you to repay your mortgage early but this seems unlikely in today's economic climate.

The endowment will also provide protection benefits in the form of life insurance or life and critical illness insurance and premium protection in the event of sickness/accident.

To summarise then, the main features of a endowment mortgage funding arrangement are as follows:

  • Repaying your mortgage is dependent on investment performance.
  • The choice of a wide variety of funds.
  • An endowment combines an investment with protection.

Pension Mortgage
With a pension mortgage the borrower effects a Personal Pension Plan or Stakeholder Pension and uses the tax-free cash sum to repay the loan on retirement. Pension mortgages offer significant tax advantages in that pension contributions attract tax relief at the contributor’s highest marginal tax rate. Both unit-linked and with-profit fund links are available.

This makes a Personal Pension a highly tax efficient means saving for the repayment of your mortgage. However, it must be remembered that the cash benefits of a Personal Pension Plan cannot normally be taken before age 50. Even then, only 25% of the fund can be taken as tax-free cash. The rest must be taken as an annual income, which is subject to Income Tax. Because of this limitation you may not be able to retire as early as you wish due to the lack of funds in your pension. Also if you wish to retire later than the due date of your mortgage you may have to access your pension fund at an inappropriate time, which may adversely affect your retirement provision.

Using your pension plan to pay off the mortgage has two other disadvantages. Firstly, in terms of the actual high payments you must make each month. Pension plans are usually the most expensive means of mortgage repayment funding, even after tax relief. This is due to the 25% tax free cash limit mentioned above. In order to repay, say a £50,000 mortgage requires you to build up a £200,000 fund in your pension plan. With an ISA or endowment mortgage, the total you are aiming for is the £50,000 actually required to pay off the mortgage.

Secondly, it is a fact of life that most people do not save enough for their pensions in any case. Committing a large proportion of your pension fund to paying off your mortgage might seriously reduce your standard of living once you retire, from what it otherwise might have been. All this said, taking out a pension mortgage does at least mean that you are putting away some money into a pension plan on a regular basis.

To summarise then, the main features of a Pension mortgage funding arrangement are as follows:

  • Repaying your mortgage is dependent on investment performance.
  • A maximum of 25% of your pension fund will be used to repay your mortgage.
  • The choice of a wide variety of funds.
  • The facility to switch funds as required.
  • The tax-efficient growth on assets held within pension funds.
  • The tax relief on the contributions you make.
  • The flexibility to vary contribution levels.

Individual Savings Account (ISA) mortgage
The third option, is an Individual Savings Account (ISA) mortgage. As with an endowment or pension mortgage, the borrower pays the interest on the loan for the full term where upon the ISA is en cashed to repay the capital borrowed. If the your fund grows faster than predicted then it may be possible for you to repay your mortgage early.

The tax efficiency of ISA's means that, all other things being equal, an ISA will grow in value more rapidly than an endowment owing to the fact that less tax is deducted along the way. ISA's are also a rather more flexible mortgage-funding vehicle than an endowment policy. The Government has stated that ISA's will be available at least until 2009. A review will then be undertaken in 2006 to give advance notice of any planned changes. At that time ISA's may continue to be available, may be replaced by a similar product, or discontinued completely.

To summarise then, the main features of an ISA mortgage funding arrangement are as follows:

  • Repaying your mortgage is dependent on investment performance.
  • The choice of a wide variety of funds.
  • The facility to switch providers with ease.
  • The tax-efficient growth on assets held within ISA funds.
  • The flexibility to vary contribution levels.

The actual sum payable on maturity will always be dependent on future market performance. If you do not maintain premiums at the necessary level then the policy will almost certainly not return the necessary capital sum and the responsibility for ensuring that an alternative repayment is in place remains your responsibility.

The above paragraphs are for information only. You should seek professional advice on the most suitable repayment method for your particular circumstances, which we would be happy to provide.



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