Personal Finance: Home truths about mortgage options

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Indy Lifestyle Online
Can endowment mortgages compare with repayment schemes which guarantee to pay off loans, or PEP/ISA plans that can offer investors tax advantages?

It is the fear that with-profits endowment bonus rates may continue to fall in years to come that has gradually swung the argument against them, particularly in the mortgage arena, where straightforward repayment options - paying off a varying mixture of capital and interest - are gaining in popularity.

The argument in favour of repayment mortgages is simple: you are guaranteed to pay off the loan. Moreover, it is claimed, one of the points in favour of endowments, their portability from mortgage to mortgage, unlike repayments, is less strong than at first sight.

Phillip Cartwright, a director at London and Country Mortgages, a home- loan broker, points out that even after a few years, a considerable portion of a borrower's debt will be paid off with a repayment loan. Taking a pounds 100,000 loan over 25 years, at today's standard rate of 8.7 per cent, capital worth pounds 9,821 would be repaid after seven years and pounds 17,055 after 10 years. If a person wanted to move to a new home at the same price, their next mortgage would take that repayment into account. Indeed, the rest of the loan would be paid off in just the same amount of time, with the same monthly payments as before.

While monthly repayments might have to rise if a larger mortgage is taken out, the same would apply with "portable" endowments: monthly premiums would go up. What is more, policyholders would usually be forced to start a new policy, paying a fresh set of initial charges, which suck a large proportion of premiums out of endowments in early years.

Mr Cartwright says: "I have always been sceptical of the so-called portability argument in favour of endowments. Repayment mortgages can be used flexibly and can be more effective than endowments in the early years."

However, defenders of endowment-linked mortgages point out that they have the potential not only to pay off a loan but also to leave borrowers with a lump sum to enjoy at maturity. Nor are combined payments that dissimilar to straight repayment loans.

Amanda Davidson, at Holden Meehan, calculates that a 25-year repayment loan of pounds 100,000, at an 8.7 per cent interest rate, would involve net monthly premiums of pounds 795.77 a month, plus a further pounds 14.76 a month in life insurance, a total of about pounds 810.53. By contrast, an interest-only loan would cost pounds 692.38 which, when added to an endowment of pounds 164, would cost pounds 856 a month.

Ms Davidson says: "You do pay more with an endowment. But as interest rates fall, costs begin to even out so that when rates are about 7.5 per cent, the cost of an endowment loan is roughly the same as a repayment one."

The difference lies in potential returns. With a repayment loan, you are guaranteed to pay off the loan and no more. With an endowment, the minimum guaranteed amount might be just pounds 52,200. However, if investments grow at just 5 per cent a year, the amount paid out would be pounds 82,900.

If investments grow at 7.5 per cent, returns would reach pounds 117,000. With growth of 10 per cent a year, returns would be pounds 168,000. For the original pounds 100,000 loan to be paid back, returns would have to average 6.3 per cent. Ms Davidson says: "It is not too unrealistic to assume growth on this scale."

Are endowments still a worthwhile investment in the age of personal equity plans (PEPs) and new-style Individual Savings Accounts (ISAs)? Ms Davidson calculates that, assuming a 9 per cent growth rate, to pay off the same loan would require monthly payments of pounds 143 into a PEP/ISA, including life cover. This would raise the total cost of monthly mortgage payments to pounds 835, less than an endowment. Moreover, returns on PEPs and ISAs are not subject to taxation on the underlying life fund, unlike endowments. They are, however, more risky.