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- Pryor on property: news and views You wouldn't go into a restaurant and tell the waiter you'll have 'whatever', because you might not like what you end up with. And you probably wouldn't book cinema tickets to watch any old feature, because it might not be your sort of film.
When we spend money we like to know what we're getting, and this applies to mortgages as much as anything else.
The different kinds of mortgage
There are essentially two kinds of mortgage - repayment and interest only. With a repayment mortgage you pay back both the interest and the capital (the amount you borrowed) over the period of the mortgage. Obviously with an interest-only mortgage you pay back only the interest and at the end of the term of the mortgage you then need to be able to pay back the loan as well.
Types Of Mortgage
There are essentially two different types of mortgage:
- Repayment only, (capital and interest mortgage) - Interest only, (ISA, pension or endowment mortgage)
Repayment only
Your monthly repayments consist of repaying the capital amount borrowed together with accrued interest. On your mortgage statement, normally received annually, you will see that the amount borrowed decreases throughout the term.
Advantages
- You know that your mortgage will be paid off in full at the end of the mortgage term.
- You can overpay or pay off lump sums into your mortgage which will reduce both the interest and capital amounts repayable.
- Life assurance cover is not always necessary in taking out this type of mortgage.
Disadvantages
- In the first few years of a repayment mortgage the majority of the monthly repayment is interest rather than capital. For borrowers who move house regularly, this can mean that little of the capital is paid off. - There may be financial penalties for making lump sum/overpayments into your mortgage account. - If you have no life assurance cover in place and die before the loan is repaid, the mortgage will still need to be repaid. This may result in the property having to be sold to repay the debt owed.
Interest only
With this type of mortgage, only the interest is paid off with each mortgage payment. So when the mortgage finishes the borrower has to repay the debt. In order to do this the borrower also has to take out at the same time, an alternative 'repayment vehicle' (method of paying off the mortgage) such as an ISA, pension plan or endowment policy. The idea is that the investment will grow over the duration of the mortgage to a large enough sum to pay off the capital. These are explained below. As a consequence it is important that the payments are maintained into the repayment vehicle otherwise it will not be possible to pay off the mortgage at the end of the term.
- Endowment
- ISA Plan
- Pension
Endowment
The most common type of interest only mortgage which also provides life assurance cover and a fixed payment for investment. These were very popular in the 1980s and 1990s. The fixed payments are based on the amount of the loan together with the mortgage term and are designed so that, at maturity, the amount invested and earnings are sufficient to pay off the mortgage. These have been much criticised of late because when the plans were taken out people were promised high returns and perhaps a surplus on the amount of the loan because the stock market was roaring away. However, in the current low inflationary economy the stock market is producing much lower returns and some borrowers have found that their investment has not produced the levels of growth expected and they might find themselves with a shortfall when it comes to paying off their mortgage. Note: there is no guarantee that, when the endowment matures and 'pays out', the balance will be sufficient to repay the mortgage.
Nonetheless millions of borrowers have one or more endowment policy and as a rule of thumb these should not be cashed-in early and certainly not before seeking advice from a suitably qualified financial adviser. If you cash in an endowment policy in the first few years after it is started you can receive less than the amount invested.
If you have an existing endowment and you want to move home your current endowments can be used to support a new mortgage. If the new house is more expensive then the extra cost - the %u2018additional lending%u2019 - over the value of the expected value of the endowment at maturity can be covered on a repayment basis.
Despite the recent problems it is worth remembering that historically the returns on endowment policies have been pretty good (as long as they go full term). Endowments provide life assurance so that in the event of death the mortgage is paid off.
ISA Plan
Here you invest in stocks and shares via an Individual Savings Account (ISA) - which is a tax-free method of saving. This is quite a complicated product so may not be suitable for most borrowers. Before considering this option you should consult with an independent financial adviser.
Pension Plan
Life assurance cover is provided and monthly payments are made into a pension fund - which has tax benefits. When the benefits are eventually taken, the mortgage is repaid using tax-free cash from the remainder of the fund. The plan holder can then draw a pension from the balance of the fund. This product, which tends to be used by the self employed, is only for those taking advice from a suitably qualified financial adviser.
Advantages
- If your investments do very well then you might have a surplus left over once the mortgage is paid off.
- Some plans are tax-efficient.
Disadvantages
- If your investments do badly and do not reach the level expected the borrower could face a shortfall which they will then need to pay - and this could be a large sum that has to be found. Regular checking of the policy fund itself by the borrower and the lender should minimise any risk. If the plan is not reaching its expected target, the borrower can increase payments into the policy or invest in another product to cover any anticipated shortfall.
- Cashing in the plans early may result in financial penalties. These will be provided for in the initial agreement. In addition the lender has no way of tracking some of the more modern repayment vehicles, such as an ISA, which will result in some instances where a borrower lets an investment lapse forgetting or not realizing it is to be used to pay off the mortgage. This will result in situations where there is no method of paying off the mortgage and the lender will only become aware at the end of the mortgage term.
For information on different kinds of interest rates - such as fixed, capped, discounted and tracker click here.
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