| There are a large number of different mortgage options
on the market – all suited to different lifestyles
and circumstances. It can be confusing understanding all
the features of the different products and knowing which
one to choose.
You need to decide:
- Do you want a repayment or interest only mortgage?
- What type of interest rate calculation do you want?
- What other special features suit you?
- If you’re looking at an interest only mortgage
– what type of repayment vehicle suits you?
Repayment or interest only?
The key decision you have to make is between a repayment
or interest only mortgage – you are either paying
only the interest on the money you have borrowed, or
both the interest and a portion of the capital.
Repayment mortgages
With a repayment mortgage your monthly repayments cover
both capital and interest on the loan. No other repayment
vehicle is needed, but your lender may insist on life
insurance in case you die before the mortgage is cleared.
On the plus side, a repayment mortgage is simple,
straightforward and easy to understand. It also avoids
the risk of investing in the stock market for your repayment
vehicle.
However, unlike a pension, ISA (Individual Savings
Account) or endowment mortgage, repayment loans do not
give you the opportunity to benefit from a rising stock
market. Also, when remortgaging, people often choose
another 25 year repayment mortgage, to keep the initial
monthly costs down. This means that the overall total
period of your mortgage debts don't reduce as quickly.
Interest only mortgages
With an interest only mortgage, your monthly payments
to the lender cover only the interest on the loan (i.e.,
they don’t repay any of the capital). The full
amount of the loan has to be repaid to the lender at
the end of the term.
To ensure you can make this final payment, you invest
additional funds in investments which are designed to
generate enough (preferably more than enough) capital
to repay the loan at the end of the term.
On the plus side, you can choose from a variety of
investment vehicles, some of which can have tax advantages.
And should you move or remortgage, your investment vehicle
can usually be reallocated to the new mortgage.
However, unlike a repayment mortgage, the total amount
of your debt does not reduce over time. And there is
no guarantee that your chosen investment vehicle will
grow sufficiently to repay your loan (although you can
usually top up your contributions to investments as
you go along if this looks likely to be the case).
Interest Options
If you choose an interest only mortgage you will also
need to arrange a repayment method to pay back the capital
at the end of the mortgage. There are a number of different
options available, including an endowment or a pension
or an ISA.
Endowment
With an endowment mortgage you make your monthly repayments
of interest to the lender and in addition you make contributions
to an insurance/investment company to fund a savings
plan. This savings plan aims to generate sufficient
funds to pay off the capital at the end of your agreed
mortgage term.
The good thing about an endowment repayment vehicle
is that you can maintain the policy if you move house
or change mortgage provider. Endowments can also include
some kind of life and critical illness cover which is
usually cheaper than buying such cover separately. If
the underlying investments perform well, you may get
more than is needed to pay off the loan.
But... if the underlying investment performs poorly,
you could end up having to review the premium subscriptions
to your endowment policy and/or the basis on which your
mortgage is operated in order to ensure that the mortgage
loan can still be repaid in full at the end of the agreed
term.
Pension
With a pension mortgage, you make your monthly repayments
of interest to the lender and you also make contributions
to a personal pension. This personal pension then provides
a tax-free lump sum as well as a taxed regular income
at retirement. Most, if not all, of the lump sum is
used to clear your mortgage loan at that date.
On the good side, pension contributions qualify for
tax relief of up to 40% (for a higher rate taxpayer),
which boosts the value of every pound you contribute
to your pension.
However, using your tax-free lump sum as a mortgage
repayment vehicle may leave you with inadequate income
in retirement. Also, the lump sum is payable on retirement,
so your loan term may be more than 25 years (depending
on how old you are and when you are planning to retire!).
The biggest problem is that poor performance could
adversely affect the amount of the tax-free lump sum
resulting in insufficient funds available to repay the
loan at the end of the agreed term. Also, you should
bear in mind that tax rates may change. You also need
to consider the possibility of joining a company scheme
after your mortgage has started. If this was to happen
you would no longer be able to have a pension mortgage
and would have to consider an alternative method to
repay the mortgage.
ISA
With an ISA mortgage, you make your monthly repayments
of interest to the lender and you also make contributions
to an Individual Savings Account (ISA). Like the PEP
mortgages which preceded them, ISA mortgages use stock
market-based investments for tax efficient growth.
There are two main types of ISA: “mini”
and “maxi”. There are different rules over
contribution levels and range of investments available
in each. If you take an ISA as a repayment vehicle you
are also likely to be required by the lender to take
out term assurance to cover repayment of the loan if
you die early.
On the plus side, if your ISA performs well, you may
be able to pay off your mortgage early.
However, a stock market crash could leave your investment
in trouble. Also, current tax rules dictate that the
maximum investment in an ISA is £7,000 per annum,
which may not be sufficient to give you confidence that
you will be able to repay a large mortgage at the end
of the term.
Notes:
Tax legislation may change.
The value of an investment is not guaranteed and
can go up and down depending on investment performance.
You could get back less than you have paid in. |
