There
are two types of mortgage available: capital and interest (repayment)
and interest-only mortgages. Interest-only mortgages can be categorised
further as endowment-linked, pension-linked and Individual Savings
Account (ISA) linked.
Capital and interest mortgages, also known as repayment mortgages, involve the borrowing of a sum of money over a chosen period, typically 25 years. They comprise two elements: capital and interest.
The borrower makes a monthly payment to the lender, made up of interest charged on the amount borrowed and a capital repayment. As the capital is gradually repaid each month, the outstanding debt is reduced. As a result the interest gradually reduces and the capital content increases as a proportion of the monthly payment.
During the early years of a repayment mortgage, most of each month’s payment is interest and it is only in the later years that this is reversed. The lender will calculate the repayments to ensure that, if they are all made on time, the mortgage will be repaid in full at the end of an agreed period.
Repayments are affected by interest rate changes and will decrease or increase in line with those changes. Following a change in the rate applicable to your account you will receive a letter advising you of revised payments.
There are two main advantages to the borrower when taking out a repayment mortgage:
•
the guarantee that if all payments are made on time the mortgage
will have been discharged by the end of the term.
• the borrower can see the mortgage liability diminishing
each year.
The main disadvantages of a repayment mortgage are listed below:
•
during the early years of the mortgage most of the monthly payment
is interest.
• the average person moves house approximately 6 times and
after each move has to start a new mortgage, therefore restarting
the same process of paying mainly interest in the early years.
With an interest-only mortgage the borrower agrees at the outset of the contract that only the monthly mortgage interest will be paid to the lender. The monthly payment does not reduce the mortgage amount and will be affected by interest rate changes, increasing or decreasing in line with those changes. Following a change in the rate applicable to your account, you will receive a letter advising you of the revised payments.
Because the payments are intended to pay only the interest, the balance of your mortgage is not reduced and the full capital amount becomes due at the end of the agreed loan period. It is now possible to take out a true interest-only mortgage and not put in place an investment vehicle to repay the capital at the end of the term. However, most people need to contribute to an acceptable investment plan that will repay the capital at the end of the loan period.
There are many types of investment plans that can be used to repay an interest-only mortgage: each type has its benefits and drawbacks. The main types are detailed in the following sections.
ISAs were introduced by the Government to encourage investment in shares, unit and investment trusts. The main attraction of ISAs is their tax-free growth. As a tax efficient means of saving, they are an attractive alternative to other methods of investment. Currently ISA funds grow with no liability to Capital Gains Tax and receive a tax credit on dividends from UK equities. If the fund is invested primarily in UK equities, the dividend distribution is made with a 10% tax credit. This 10% credit may be reclaimed by an ISA. Distributions from non-equity trusts are in the form of interest income. 20% tax credits are available on these distributions.
Payments into ISAs are most commonly invested in collective investment vehicles (unit trusts or investment trusts). Payments into the fund are calculated to repay the mortgage at the end of the agreed period. You should be aware that the value of your ISA can fall as well as rise. It is generally accepted that when compared to investing in typical managed funds available in endowments, this method of repaying a mortgage carries a higher degree of risk. There is no guarantee that the accumulated funds will be sufficient to repay the mortgage on its expiry as the proceeds depend upon the investment returns achieved, which may be greater or less than the assumptions made at the outset. You may end up with a significant surplus at the end of the mortgage period but you may also be required to meet a deficit.
The main advantages of ISA linked mortgages are listed below:
•
compared to other investment vehicles, ISAs have lower charges
and you should expect to pay less charges during the term of the
mortgage.
• there is no set term when investing in an ISA and therefore
when compared to pension linking or endowment linking this gives
you more flexibility.
The main disadvantages of ISA linked mortgages are listed below:
• they are not guaranteed to repay your mortgage at the end of the term and you could be faced with a shortfall.
• generally speaking ISAs carry a higher risk rating than a typical managed fund that would be used by endowments (though this can be offset by selecting lower risk ISA funds such as Corporate Bonds, Gilts, Cash or other Fixed Interest Securities).
Traditionally personal pension plans are used to provide an income in retirement. Under current Inland Revenue rules, the accumulated pension fund can be used in two ways:
•
to provide a full pension.
• to provide a reduced pension and a tax-free cash lump
sum that can be up to a maximum of 25% of the accumulated fund.
Contributions currently receive tax relief and the pension funds benefit from a favourable tax treatment: with the exception of tax credits on UK shares, there are no taxes levied on pension funds. The value of tax relief depends upon personal financial circumstances. These tax concessions have made tax-free cash from personal pension plans a popular methods whereby to repay mortgages.
As with unit linked endowments the value of investments can go down as well as up and there is no guarantee that the tax-free cash will be sufficient to repay the mortgage at the end of the term. The consequences of the tax-free cash producing a surplus or deficit when paying off the mortgage are the same as those laid out for low cost and unit linked endowments.
The main advantages of pension linking are listed below:
•
tax relief on contributions.
• part of the fund can be taken as tax-free cash, which
is used to repay the mortgage.
• favourable tax treatment of funds.
• a sum can be built up which can be used to provide an
income in retirement.
The main disadvantages of pension linking are listed below:
•
benefits can only normally be taken between the ages of 50 and 75.
• the amount of tax-free cash is limited by legislation.
• a person may become ineligible to contribute to a personal pension plan
and will need to make other arrangements.
• there are limits on pension contributions.
• using tax-free cash will reduce your pension benefits.