Mortgage repayment methods

Capital repayment method

The most popular method of recent times, with this method, monthly payments consist of a capital (the loan) amount and an interest amount. Providing the borrower maintains their mortgage payments on time then this method guarantees that the loan will be repaid at the end of the mortgage term. At the begining of the mortgage term, the monthly payment consists largely of interest. The amount of capital owed gradually reduces at the term progresses; the interest part of the monthly payment decreases, while the capital element increases.

Interest-only method

With this method the borrower makes monthly payments of interest only. Therefore the full capital amount (the loan) remains outstanding during the mortgage term and is repaid in one lump sum at the end of the term. Mortgage payments will be lower however the borrower should arrange an investment vehicle to build up the savings required to repay the mortgage at the end of the term. However, in most cases no guarantee is given that the investment will be sufficient to repay the debt in full. There are four different types of investment vehicle: -

• With-profit endowment policy
• Unit-linked endowment policy
• Individual savings accounts (ISA)
• Personal pension plan

There are variations on all of these as providers tweak their products to gain advantage in the market place.

With-profit endowment policy

This policy consists of a guaranteed sum assured which will be paid at the end of the term assuming premioums have been payed up to date. AS well as the guaranteed sum assured the policy often (but not guaranteed) includes reversionary bonuses which are added each year.

The 'full with-profits endownment' was the original repayment method for mortgages however this is rarely available these days and the premiums would be are very expensive. It is now more common to find a low-cost with-profits policy where by the guaranteed sum assured is typically 50-60% of the mortgage amount. The low-cost with-profits policy therefore is not guaranteed to repay the mortgage at the end of the term.

The with-profits endowment policies include builtin protection in the form of term assurance which will payout on death of the policy holder(s).

Unit-linked endowment policy

This policy is designed to accumulate capital by the end of the mortgage term. It difers from the with-profits endownment in the way that the fund is built up. Your monthly premiums buy units in one or more of unit-linked funds. The value of these units is directly related to the performance of the fund. Therefore if investment funds grow say at an annual rate of 7.5% the maturity value should be sufficient to repay the loan at the end of the mortgage term.

The only guaranteee offered is that the loan will be repaid in the event of death during the term. As the fund is invested on the stock market unit prices can and do fluctuate.

Endowment shortfalls

The performance of many low-cost with-profit and unit-linked plans have been very poor since the mid 1990s, reasons for this are: -

• inflation and interest rates being much lower.
• falling share prices both in the UK and foreign markets

Individual savings accounts (ISA)

These were introduced on 6th April 1999. They replaced personal equity plans(PEPs) and tax-exempt special savings accounts (TESSAs) from that date. There are two forms of saving in an ISA the simplest is the Cash ISA, this is effectively a tax free savings account. The other type is an Equity ISA which can be held in a number of investments (e.g. shares, bondsm, trusts, etc). The chanceller has announced that from the 6th April 2008 the overall ISA limit will increase to £7,200. The cash ISA limit will increase to £3,600. Therefore equity ISAs will be reduced from £4000 to the remaining £3,600.

Personal pension plan

Money invested into a personal pension can be used as the repayment vehicle for a mortgage however, there are strict restrictions. The benifits of the pension can only be taken from the age of 50 (55 from 2010) and before a 75th birthday. Only 25% of all the pension funds value can be taken as a tax-free lump sum, therefore the pension fund must be at least four times the mortgage value.