Repayment vehicles

With interest-only loans, the capital will be repaid from the proceeds of a suitable investment. Essentially, any arrangement that can be used to accumulate a capital sum could be used for this purpose, although some lenders will restrict the options available to its borrowers and in some cases may require that the vehicle can be assigned to them as additional security. This limits the choices since some arrangements (particularly endowment policies) can be assigned, while others such as pension arrangements or ISAs cannot. The main options are covered in this section.

Endowment mortgages

These are so named because an endowment policy is used to repay the outstanding loan at the end of the mortgage term or upon death, whichever is the earlier. During the course of the mortgage, premiums are paid to a life assurance company for the endowment policy and interest only is paid to the lender. A variety of endowment policies may be used.

Types of Endowment

 

With-profits endowment assurance
Full with-profits endowment policies where the basic sum assured equals the loan are the most expensive repayment vehicles, but all bonuses accruing - both current and terminal - are in addition to the sum assured and form a surplus at maturity.

Low-cost endowment policies
Low-cost endowment policies come in a variety of forms. A combination of with-profits endowment and decreasing term assurance is used so that some of the bonuses are used in the loan repayment - and while they are accruing the decreasing term assurance makes up the death sum assured. Low-start versions of these are available.

However, it should be noted that low cost/low start policies are likely to prove more expensive over the full life of the policy. The premiums increase over the initial five/ten-year period to a level exceeding those of an equivalent endowment policy. The premiums then remain at that level for the remainder of the term.

Unit-linked endowments
Unit-linked policies may also be used to repay loans. Premiums less expenses are used to buy units in the life office's funds. The policies have a guaranteed death sum assured equal to the amount of the loan. Initial projections in the quotation for a policy are based on an assumed growth rate but the maturity value will be the total value of the units at the maturity date.

Adjustments to the loan arrangements or the policy will have to be considered if the projected value falls below the amount of the loan. There is the prospect of a surplus at maturity, and the policy may be reused on moving house, so in that sense it is portable.

Watch Out!!
With most repayment vehicles, including endowment mortgages (unless the initial guaranteed sum assured is equal to the amount of the loan) there is no guarantee that full repayment of the loan will be possible from the proceeds at maturity.

Although conservative assumptions are generally used in determining the contribution levels required, results will not always be as anticipated, and there have been examples where, for example, the term of endowment policies has had to be extended in order to allow the necessary maturity value to be built up.

Pension mortgages

These work in the same way as endowment mortgages in that they are interest-only, with repayment of the mortgage being achieved from the tax-free cash sum available at the time benefits are taken under a personal pension or retirement annuity. The client therefore must be, and remain, eligible for a personal pension or an existing retirement annuity contract.

Advantages and disadvantages

The main advantage is that full tax relief is available on personal pension and retirement annuity contributions; this approach is therefore particularly suitable to higher-rate taxpayers. One consideration however must be the possibility of change to the tax treatment of these arrangements, as for example in the July 1997 Budget, when the ability of pension funds to reclaim tax deducted at source from dividends was ended.

The main disadvantage is that, if the borrower ceases to be eligible for a personal pension or retirement annuity, he will have to change to another repayment method. It also reduces the fund generally available at retirement for the client's benefit.

Pension policies cannot be assigned in the way that endowments (for example) can, and this may mean that some lenders will not accept this method of repayment.

It is usually necessary to take out a separate life assurance which is assigned. This life cover could be established under personal pension rules and so qualify for relief, and life cover in this form is capable of assignment, as are ordinary life assurance policies.

Often there will be a minimum age to take up the pension mortgage which, of course, has to run to retirement age.