Save now, pay later

Interest-only mortgages need sound investment plans for an assured final pay-out, says Stephen Pritchard
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The Independent Online

According to figures from the investment company Fidelity, last year as many as three million people were holding Isas, Personal Equity Plans (Peps) or unit trusts in order to pay off their mortgages. This is despite the turmoil world stock markets have experienced since 2000.

According to figures from the investment company Fidelity, last year as many as three million people were holding Isas, Personal Equity Plans (Peps) or unit trusts in order to pay off their mortgages. This is despite the turmoil world stock markets have experienced since 2000.

Investment-backed mortgages - where homebuyers take out an interest-only loan, and pay money into a separate financial vehicle that should pay off the principal -- have declined in popularity following the controversies around endowment policies.

For years, endowments were the most popular way to repay an interest-only loan, supported by Government tax breaks. But accusations of mis-selling and poor investment performance have reduced new endowment mortgage business to the point where many of the large national firm of financial advisers say they do little or no new endowment business.

Endowments are not, though, the only way to tie paying off an interest-only mortgage to the performance of the stock market. Isas, pensions and investment funds such as unit trusts can also be set up to pay off a mortgage.

The potential benefits of an investment-backed mortgage should be twofold. An interest-only mortgage is significantly cheaper than a repayment loan ( see graph, right). And given that the stock markets usually outperform other investment classes over the long term - such as the typical 25-year term of a mortgage - home owners might even end up with a cash surplus.

Isas have become the most popular investment for paying off a home loan because of the tax breaks they offer: any growth from investment funds, and any interest on cash, is paid tax free. However, from April 2006 the Government plans to cut the maximum Isa holding from £7,000 to £5,000. This could well limit homeowners' abilities to save. Coupled with the poor investment performance over the past few years, some investors could be left struggling to pay off their mortgage principals.

However, Anna Bowes at independent financial advisers Chase de Vere, says that most home owners should not worry. "For the majority of people, the Isa wrapper is just an incentive to save. Having an equity Isa is only an issue if you have a serious capital gains tax issue, and most people do not. The rule changes do not mean you cannot invest: you can simply move into unit trusts and OEICS (open-ended investment companies)."

Ms Bowes points out that investors might have to pay more attention when they sell their holdings, in order to lock in any growth and make use of their annual capital gains tax allowances. But as investors should be moving their holdings into cash towards the end of their mortgage terms - to minimise the risk from any market falls - this should be part of the plan anyway.

Homeowners who want to use investment funds do also need to be disciplined, and resist the temptation to withdraw money early. Endowment policies typically run for the same term as the main mortgage, with severe penalties for cashing in early. Isas and standalone investment funds have no such restrictions, although this flexibility has other advantages: if funds are doing well, it is possible to sell and hold cash instead, locking in gains. Investment proceeds could also be used to repay part of the loan. Homeowners who are prepared to take the long-term view could also look at using money from a personal pension to repay an interest-only mortgage. Pensions, including Stakeholder plans, allow savers to take a cash sum of up to 25 per cent of their fund tax free at retirement. This money can be used to pay off a mortgage.

Saving into a pension also has significant tax breaks, especially for higher earners. Tax relief at the basic rate is given at source, and investors can reclaim higher rate tax through their annual tax returns. This gives a significant boost to the pension fund over time. But there is no way to access funds before retirement, and savers still have to buy an annuity (income) with three-quarters of the money.

Tying a pension and mortgage together has tended to appeal most to higher earners, not least because homeowners need to be able to save a significant amount, on top of their normal retirement planning needs, to build up a large enough fund to also repay a mortgage.

Although any adult can make annual contributions to Stakeholder pensions of £3,600 a year, including basic rate tax relief, anyone with sufficient earnings can pay more; the exact amount depends on age, and rises as the saver nears retirement.

"A pension can certainly be an efficient way of paying off the mortgage, but you do have to have a large enough lump sum to be able to do it," says Ms Bowes. You either invest to provide an income, or you can use investments to cut your outgoings, such as by repaying the mortgage. Both have the same effect."

Financial advisers caution, though, that homeowners should not be looking at interest-only mortgages, whatever the investment vehicle, if they are wary of risk. "If you are someone who is nervous about investment performance, you should take out a repayment mortgage," says Chase de Vere's Ms Bowes.

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