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Mortgages
Repayment vehicles
There are two basic options available:
A repayment mortgage, where you repay the lender on a monthly basis a mixture of capital and interest from day one and where the amount of loan outstanding gradually diminishes over the term. An interest-only mortgage, where the monthly payment to the lender consists only of the interest on the loan with no element of ongoing repayment of capital.
Repayment Mortgages (capital and interest mortgages) have certain advantages. The debt will reduce with each monthly payment made (albeit the reduction will be gradual in the early years) and as the debt reduces the amount of capital repaid increases, thus increasing your equity in the property. In addition, making payments in full as they fall due guarantees that the mortgage will be repaid in full at the end of the term.
When using this method of mortgage repayment, it is always recommended to also take out a life assurance policy to cover the outstanding debt if you die before the end of the term.
You should be aware that in the early years of the loan, you are actually paying back very little capital as most of your money will be paying the interest. As the mortgage term progresses, the proportion of capital being repaid will increase as the amount of interest decreases. In the last few years of the loan, most of your monthly payments go towards repaying the capital.
Interest-only mortgage. As you are only paying the lender interest, you will need to set up an investment vehicle designed to pay the mortgage off after a certain period. There are 3 main ways of doing this:
· Pension Mortgage · Endowment Mortgage
With a pension mortgage, the borrower effects a Personal Pension Plan 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.
Personal Pension Plan holders are entitled to take 25% of their pension fund as a tax-free lump sum on retirement and it is this amount that will be used to repay the mortgage.
Using a pension plan to pay off the mortgage has two other disadvantages. Firstly, in terms of the actual payments that must be made each month, as pension plans are usually the most expensive means of mortgage repayment. This is due to the 25% tax free cash limit, for example, to repay a £50,000 mortgage would require a £200,000 fund in a pension plan.
Secondly, it is a fact of life that most people do not save enough for their pensions and to commit a large proportion of pension fund to paying off a mortgage might seriously reduce a person’s standard of living in retirement. However, by taking out a pension mortgage it does at least mean that provisions are being made for a pension plan on a regular basis.
If an endowment mortgage is used, premiums on an endowment policy are paid to 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 be needed or other alternatives put in place to meet the shortfall.
Depending on the performance of the policy, there is a possibility that it will produce more money than is needed to repay the mortgage and a surplus in the form of a ‘cash bonus’ will be paid. The lower the growth rate assumed, the more likely the policy is to build up the required maturity value to repay the mortgage on the due date. However, the lower the growth rate assumed, the higher the monthly premiums required will be.
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