The Repayment Mortgage

How they Work
This is the simplest type of mortgage. The payments you make to the lender every month pay off both the capital and the interest from the loan. Provided you keep up the payments, you are guaranteed to pay off the loan by the end of the term agreed (usually 25 years). The lender calculates your monthly repayments depending on the amount borrowed, how long for , the interest rate & how the rate you have chosen is set.

Things you should know

1. It's the safest way of paying off your mortgage. No reliance on investment plans of any sort. So long as you pay every month, your mortgage gets paid off.
    
2. Because the capital & interest pay back are rolled into one monthly payment, repayment mortgages are more flexible than interest only mortgages, if you get into payment difficulties. If in difficulty, the lender might agree to extend the term of the loan, and thereby reduce your monthly payments. See repayment difficulties.
    
3. Some people say it's unsuitable if you move home frequently. This is true if the lender will not allow you to transfer the mortgage to your new property, but nowadays most will. Check it out though.  
    
4. Knowing how your prospective lender calculates it's interest rate can be very important, especially if you hope to pay off part of the mortgage with lump sums as you go. (In which case it's worth your time looking at flexible mortgages)

Suitability
A repayment mortgage may be suitable for you if one or both of the following describes you & your circumstances:

• You do not like to take risks.
• Your borrowing requirement is for a shorter period (say 15 years or less).

It's most suitable if you do not like to take any risks when it comes to getting the mortgage paid off.

If your mortgage will be for a relatively short term (say 15 years or less), then again a repayment mortgage is probably going to be best. This is because interest only mortgages usually rely upon a separate investment plan such as an endowment, ISA or pension, to pay off the capital. The shorter this plan runs for, the greater the risk that it will fall short of it's target. Below ten years, investments are much more susceptible to large movements in the stock market.

By switching lenders several times during the term of a loan, borrowers are able to achieve considerable savings on the overall cost of the mortgage.

Interest Only Mortgages

Don't you mean endowment mortgage?
For many people, interest only mortgages are called 'endowment mortgages' or even 'pension mortgages', but strictly speaking these names describe an interest only mortgage plus the method by which it is repaid. In other words, an endowment mortgage is an interest only loan that is repaid by the proceeds of an endowment policy etc.

How they Work
An interest only mortgage is where the lender (a bank or building society usually) only charges you interest on the loan you've agreed. (The clue is in the name!) You don't pay the capital back until the end of the mortgage, 25 years or whatever period agreed. The lender will usually ask you at the outset, to provide an investment plan of one type or another to repay the loan at the end of the term, such as an endowment policy or ISA savings plan, but sometimes they will leave the repayment plan entirely up to you.

Every month, you then pay this interest to the lender for the duration of the loan (usually 25 years). The lender calculates your monthly repayments depending upon how the rate you have chosen is set. At the end of the loan period, the lender will expect to be paid in full the initial capital they lent you by whatever means you have arranged.

To tempt you to take their deal, lenders will often offer attractive rate plans, though these usually only apply for the early part of the arrangement.

Things you should know

1. Because the repayment of the mortgage is usually dependent upon an investment plan, it is considered a higher risk than a traditional capital repayment type. However, It depends upon your circumstances (see suitability) and the method you are using to repay the outstanding loan. Don't make a decision without knowing the facts & how they pertain to you, in other words seek independent advice!
    
2. It can be less flexible in times of payment difficulties than a capital repayment arrangement. You may be able to restructure the loan over a longer period & so adjust the monthly repayments, but you may find that it is not so easy to adjust your investment plan to ensure the two are still in sync. However, flexibility is less of an issue if the interest only loan is structured as one of the new flexible mortgages.
    
3. Understand the difference between interest & APR.

Suitability
An interest only mortgage may be suitable for you if one or all of the following describes you & your circumstances:

• If you believe your investment can generate a cash surplus at the end of the mortgage term
• You believe the risk of your investment not paying off the mortgage is acceptable
• Your mortgage loan will be for at least 15 years

It can be suitable to people who feel confident that their investment provisions will match their mortgage requirements. Who are not averse to the higher risk this type of mortgage represents, because of the benefits it offers them. In other words they feel the pros can outweigh the cons. The risk element is because the repayment of the capital is at the mercy of your investment plan. If your investment performs below expectations, you could find that at the end of your mortgage there is still a bill for you to pay. However, this risk element largely depends upon the type of investment used and the features that are built into it.

Interest only mortgages are, as stated, entirely dependent upon some sort of investment plan to actually pay the debt off, such as an endowment, ISA or pension. The shorter this plan runs for, the greater the risk that it will fall short of it's target. This is because investments that run for a short period are much more susceptible to large movements in the stock market than ones that run for a long term. If your mortgage is going to run for less than fifteen years, the safest option might be to take out a repayment type.

Don't be afraid to re-mortgage your loan with different lenders throughout it's life. For example, if your five year capped rate has just ended, and there are no hangover redemption penalties, you can simply shop around for the next suitable deal. Re-mortgaging can result in considerable savings over the term of the loan.

Repaying the loan
At the same time the mortgage starts, the borrower puts in place a means of repaying the capital borrowed, at the end of the mortgage term. In theory, anything that will pay off the capital at the end of the term can be used, but in practice most lenders will prefer or insist it to be one of the following:

• An endowment policy
• A pension plan
• A stakeholder pension
• ISAs

Endowment policies
Popular in the eighties, endowment policies come in several forms which basically all do the same thing. They bundle a life assurance policy and a savings plan into the same product, for which the owner pays a monthly bill or premium. In it's standard form the life assurance element will only cover the policy owner, but it is very easy to arrange the policy in joint names for those buying with a partner, in which case the life assurance element pays out on the death of either partner.

Pension Plans
Using your pension to pay off a mortgage is actually the most tax efficient way of doing so, however this method is really only suitable for a small number of people, and even then there are significant cons to consider against the tax pros.

In theory any pension that provides a lump sum in retirement can be used, but in practice only Personal Pension Plans or Stakeholder plans are considered by lenders. In short, all or some of the lump sum from the pension is used to pay off the mortgage capital at the end of the term.

ISA's
If a pension mortgage doesn't suit your circumstances, another option is the ISA mortgage. Although an ISA mortgage doesn't enjoy all the tax benefits of a pension mortgage, it does enjoy some of them. ISA's also have tax advantages over endowments and usually working out cheaper as a result of lower charges.

A Generic Example
If you overpay your loan by £50/month for say five years on a flexible mortgage, that cumulative amount is then made available as a cash reserve for you to draw on at any time during the remainder of the mortgage term. This cash reserve can normally be drawn on for such things as, taking payment holidays or making large purchases. Indeed some lenders actually issue the borrower with a cheque book and encourage them to use the account as an all encompassing bank account (see below). However the amount you can withdraw is limited by the original sum of the loan.

The main benefit of borrowing against your 'mortgage account' is that mortgages are usually the cheapest form of borrowing. In other words, you'll pay less interest on the amount you borrow!

If on the other hand, you overpay but never make any withdrawals, you can save a significant amount of interest over the life of the loan. This is because most lenders who offer this type of loan calculate the interest you pay on a daily basis (see what to look for), therefore any overpayment comes immediately off the debt and interest payments are adjusted accordingly.

Using a flexible mortgage as a bank account:
Some lenders allow their flexible mortgages to be used as a bank account. With this type of flexible mortgage, your salary is paid directly into your mortgage account, just as if it were an ordinary bank account. Any standing orders, bills and direct debits are taken out of your account on a monthly basis just as you would normally do. However, By paying your monthly salary directly into your mortgage account your wage will be used to reduce your overall loan. You can then withdraw cash as and when you need it throughout the month until the next pay cheque comes in. You’ll save on interest payments whilst your salary remains in the account.

Choosing a Mortgage
Choosing the right method of interest repayment on your new mortgage is just as important a decision as choosing the type (capital repayment or interest only). The right decision here will help provide a loan that fits in with both your personal & financial circumstances.

In the UK today there are five main methods available for structuring the interest rate on your loan.

The following table should only be used as a very approximate guide. Specifics will vary from provider to provider.
 

Understanding Interest & APR
Understanding the difference between the two, & the rules lenders apply, can help prevent you from making a very expensive mistake.

Interest Rate
The main rate you see advertised by the lenders. It simply declares the interest rate that you will be charged on your loan without any other costs such as arrangement fees included. As such it is not a true representation of the 'cost of borrowing'.

APR (Annual percentage rate)
Introduced by the government in 1974, it's an attempt to force all lenders to quote the true cost of borrowing, by including all the associated costs of setting up a loan. In the case of mortgages this means costs such as arrangement fees, valuation fees & mortgage indemnity insurance are all included. It follows that the APR rate will always be higher than the basic interest rate quoted.

The problem with mortgages & APR is that lenders are allowed some flexibility in how they actually quote their APR. This means that you still can't be sure that the APR you are looking at in an advertisement would be the APR you would pay!

Different methods of charging interest
Be aware of how your mortgage lender charges interest. Most of the new flexible mortgages on the market apply interest on a daily basis & then adjust it monthly. This is a significant advantage because it means that you only pay interest on the actual amount of loan outstanding. If you are able to pay extra capital off at any time, the interest charges will reflect this change immediately, reducing your monthly repayments accordingly.

Most traditional mortgages on the other hand adjust interest rates either monthly or annually.

Interest adjusted monthly.
Probably the most common method of applying interest, the bank or building society adjust the interest rates monthly if necessary, although in practice only when the base rate changes. The effect of a monthly appraisal of interest is that if you make repayments above your normal monthly repayments (to pay off the loan early etc.) you can end up being charged interest on capital you might have already paid back, for up to one month.

Interest adjusted annually
This is the one to be wary of. The lender applies a single interest rate to it's borrowers which it adjusts just once a year. The problem with this is that if interest rates rise a couple of times through the year, the following year the lender effectively slams a double whammy on its borrowers. First of all it increases the interest rate in one jump to the new prevailing level & then it increases it further to make up for the low interest rates the borrower paid in the previous year. The effect of this is that the borrowers can suddenly find their mortgage making a large, unmanageable jump up at the start of the new mortgage year. This method of interest adjustment is usually applied by Building Societies, though by no means all of them. Avoid it if you can.

The Upshot
Whatever type of mortgage you've got, be aware of the effect of annually adjusted loans. If you like or intend to make extra payments to reduce your mortgage debt, consider other options such as a flexible mortgage.

Pension Mortgages

Using just your pension and the taxman to pay off your mortgage sounds tempting, but be fully aware of the repercussions on your retirement income.

How it works
If you use some of the proceeds of your pension to pay off your interest only mortgage, the taxman will, in effect, be paying off some or all of your mortgage for you!

In brief, pensions enjoy unique tax concessions. Whenever you contribute to your pension fund, so does the taxman (it's called tax relief). The result of this is a significant portion of your retirement fund comes directly from the taxman's contributions. When you retire, you're allowed to take a portion of this fund as a tax free lump sum. In the case of a personal pension, this is 25%, so, providing the lump sum is large enough to pay off your mortgage debt, the tax relief can, in effect end up paying off the mortgage for you.

First of all the fund is not going to become available until retirement. Whilst it's possible to retire at 50, for most people retirement will come when they are aged 60 to 65. It follows that if a pension mortgage were started by a 30 year old man, he could be paying interest on his mortgage loan for up to 35 years, obliterating any tax advantage the pension mortgage offered!

Another disadvantage is the effect it will have on retirement income. In theory, a personal pension, funded to the maximum throughout it's life, could provide both a good pension & pay off the mortgage with lump sum to spare! However in practice, people tend to grossly under fund their pension, so they often need the lump sum to supplement their retirement income. If all of the tax free lump sum is used to pay off a mortgage, the remaining pension income may prove to be insufficient.

Suitability
A few lenders will allow you to secure a pension mortgage against a pension company scheme provided you take out an AVC or FSAVC, however the vast majority of lenders will only consider lending against a stakeholder pension or a personal pension plan. For this reason pension mortgages can be considered suitable for the self employed & those in employment who have no access to a company pension scheme or do have access to a stakeholder scheme. In other words the same people stakeholder and personal pensions are usually appropriate for.

If you are considering a pension mortgage, you should make sure the two points mentioned earlier are well covered. Make sure that your expected retirement age doesn't mean you'll end up paying interest for an excessive term and also make sure you can afford to fund this option. Pension mortgages are tax efficient but that doesn't mean they are cheap. You will have to make sure your pension is strongly funded throughout your working life if it's to stand a chance of providing you with a decent retirement income.

We would strongly advise anybody considering a pension mortgage to come and see us first, independent financial advisers.

The Risks
Besides the points already mentioned, when considering a pension mortgage, there are some considerable risks that need to be taken into account. For instance, if for any reason you are not able to work, and this results in you not having any net relevant earnings, you would no longer be able to contribute to a personal pension. (You can however contribute to a stakeholder pension even with no net relevant earnings. see stakeholder pensions) Therefore a separate repayment vehicle might have to be considered. On the other hand, if you change jobs and are suddenly eligible for an occupational pension scheme, you may benefit from joining it, however an occupational scheme would most likely not be acceptable to your lender.