First-time buyers

Repaying a mortgage

There are two basic methods of repaying a mortgage – Repayment (capital and interest) and Interest-Only, which uses the proceeds from an investment plan (endowment, pension or ISA) to pay off the mortgage.

Repayment (Capital and Interest)

This is by far the most popular option for mortgage borrowers and has been since the late ‘90s.
Each month you pay a sum of money to you lender, which consists partly of the interest you owe on your loan and partly repayment of your outstanding capital debt,
This method of repaying a mortgage is completely safe.  As long as you keep up with all of your monthly repayments in full throughout the mortgage term, the loan is guaranteed to be repaid.
A repayment mortgage may initially appear slightly more expensive than an interest-only loan, but most people consider the price well worth paying for the security this type of loan offers.
However, do bear in mind that if you move home, you will have to cash in your loan and start again from scratch.  In the beginning you will be paying off mostly interest, so if you sell up in the early years you will not have paid off much capital.  But after a few years you will be whittling away at bigger and bigger chunks of capital, steadily reducing your debt.
Remember, when you take out a mortgage it is important that you also take out a life insurance policy, which will pay off your debt if you should die during the mortgage term.  This insurance is imperative if you have dependants.
With a repayment mortgage you have to arrange life insurance separately.

PROS
• Easy to understand
• Loan is guaranteed to be repaid

CONS
• Need to start a new loan each time you move
• Separate life insurance is required

Interest-only

Following new lender legislation and regulation in April 2014 this type of lending has seen a marked decrease. Nevertheless they are available in some circumstances so here are the details.

Your monthly payments to the lender consist simply of the interest that you owe throughout the mortgage term, and you pay back none of the outstanding debt until the end of the mortgage term.
As well as your monthly payment to your lender, you should also make a payment into a separate investment or savings plan (ISA, endowment policy or personal pension), the proceeds of which are designed to pay off the capital.  The value of the investment may be greater than the outstanding loan, leaving a surplus lump sum.
However, there are no guarantees that your investment or savings plan will generate enough money to pay off the capital you owe at the end of the mortgage term.
The lender is not obliged to ensure you have a suitable investment or savings plan in place.  The onus is on you, the borrower, to make sure you have an investment or savings plan, and to monitor its progress.  You may need to increase the amount you put away each month if you feel your investment is not growing as quickly as expected

ISA
An ISA (individual savings account) is a form of investment that enjoys tax benefits – growth/interest is largely tax-free.  So if the plan performs well you could be left with a surplus after the mortgage has been repaid, or you may be able to pay off the loan several years in advance of the expected date.


The rules surrounding ISAs are may seem a little complex, but basically as they have tax benefits there are limits on how much you are allowed to invest each year.
If you select an ISA to repay your home loan, you may have to arrange life cover as well.

PROS
• Tax-efficient investment
• Possible surplus lump sum
• Possible early repayment

CONS
• Separate life cover may need to be arranged
• Tax-free benefits not guaranteed
• No guarantee that the loan will be repaid


ISA limits

From July 2014 all ISA's (cash and equity/stocks and shares) are equal and have a £15000 per year investment limit

This is enough to cover most mortgages.

Endowment
This used to be the most popular type of investment linked to an interest-only mortgage, but today lenders don’t offer endowments, as there is increasing concern that they won’t perform well enough to repay borrowers’ loans.  This is due to falling investment returns.
In fact, in recent years endowment providers have been obliged to write to millions of customers, warning them that they are very likely to face a shortfall when it comes to paying off their mortgage.

PROS
• Potential for surplus growth

CONS
• Possibility of insufficient growth

Endowments are life assurance policies which do not continue for the whole of one's life but come to an end on the maturity date or on the earlier death of the life assured.
The term between commencement and maturity date is a number of years chosen by the policyholder at outset. Almost any term is possible, provided that it is more than ten years and ends before the life assured reaches a given age, such as 65 or 75 years.
During this term, the policyholder pays a regular monthly or annual premium. The benefits of the policy will be paid if the life assured either survives to maturity date or dies earlier.
Endowment policies are the most expensive form of life assurance. Since they pay out on a given date or earlier death, they provide a savings plan capable of achieving the saver's goals whether the life assured lives or dies. They therefore need consideration for purposes such as paying off a mortgage.

Endowment policies can be provided in several different formats:
• as a full endowment policy with-profits
• as a low cost endowment with-profits
• as a unit linked endowment

As no financial adviser will recommend and no providers offer mortgage related endowment plans any more, further information regarding existing plans can be found on the insurance companies' websites.

Pension

Following the 2014 March Budget, the payment of lump sums from pensions (tax free or otherwise) is under consultation and will be confirmed in the Pensions Bill due towards the end of the year. Therefore the following information is based on pre March 2014 understanding.

It is possible to use some of the proceeds from a personal pension plan to repay a mortgage.  Since personal pensions have built-in tax benefits, there is the potential for a greater return than from an endowment policy.
But you should remember that your pension is designed to provide an income during your retirement years, and there are strict limits as to the amount of money that can be taken as a tax-free lump sum – 25% of the plan’s value is the maximum.  So if, for example, you had a £100,000 interest-only mortgage backed by a pension, at the end of the mortgage term you would need a pension pot of £400,000 to repay your capital debt.
You must consider if it makes sense to use a sizeable proportion of your hard-earned savings to clear your mortgage.  You may need to arrange separate life insurance cover.
And note that mortgage providers are banned by legislation from advertising pension mortgages, which may indicate just how risky this option can be.

PROS
• Tax-efficient investment

CONS
• Uses valuable retirement funds
• Cannot access money until you are at least 55
• There is no guarantee that your pension pot will grow sufficiently to repay your mortgage debt.




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