Numbing the pain

As buyers confront the boom, Nic Cicutti assesses how best to repay a loan
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The Independent Online
Each month, tens of thousands of prospective home buyers enter the property maze, buoyed by the seemingly relentless rise in house prices of the past few months. After the first flush of excitement, when a buyer hears their bid has been accepted by the seller, comes the hard decision: just where is the money to be borrowed from and how will the debt be paid off?

There are several ways of paying off a home loan. One that regained its popularity in recent years is the straightforward repayment mortgage.

Under the arrangement, every monthly payment involves paying off part of the capital borrowed and a slice of interest. The exact amount of each changes over the borrowing period, with repayments skewed so that in the first five years or so, nearly all payments are of the interest. Thereafter the ratio of capital to interest repayments alters quite quickly.

A repayment mortgage will at first sight seem dearer than an interest- only one. On a typical pounds 50,000 loan, repayments based on a 7 per cent variable rate over 25 years will cost pounds 409.20 a month.

That compares with pounds 265.60 a month for the interest payments alone, a difference of pounds 143.60. But borrowers taking out that kind of mortgage will still have to find an alternative mechanism for paying off their loan.

Ian Darby, marketing director at John Charcol, the largest mortgage brokers in the UK, says: "Repayment mortgages are the most flexible in that you can increase or reduce the amount you pay each month simply by lengthening or reducing the repayment period."

But he points out that the "front-end load" on the loan, with little except interest being paid in the first few years, can be dangerous. "If you move after five or six years, you have paid hardly any of the capital off, which means that you may have to start all over again."

All other mechanisms for meeting the capital debt on a mortgage involve setting up a parallel repayment system, usually investment-related.

The most common is the endowment. That is a relatively low-risk investment into which payments are made over 25 years (sometimes less), in the expectation that the value of the sum at maturity is greater than the value of the mortgage taken out.

Endowments can be either unit-linked, reflecting stock-market ups and downs, or with-profits, in which a bonus is added to the policy every year and a final payment paid at maturity.

Ian Darby says: "Endowments are better value than is sometimes claimed. They offer cheap life cover, they involve a cautious investment strategy and the fact that once a bonus is added to a policy it cannot be taken away means that it offers some protection against down-turns in the market."

Mr Darby adds that they are, however, a long-term investment and can be inflexible for people who stop payments early for perfectly legitimate reasons, such as divorce or redundancy.

Because the setting-up charges are levied at the start of the policy, people "surrendering" an endowment in the early years risk receiving less than they paid in.

One investment growing in popularity is the personal equity plan, or PEP. These are schemes whereby savings in the PEP roll up and are paid tax-free, unlike endowments, where 18 per cent or so is levied.

PEPs are flexible: it is possible to stop and start payments into them at will, without penalty. Charges are spread throughout the life of the policy, with no heavy up-front fees.

Most PEPs also involve a significant degree of risk and may not be suitable for people who do not want to take a chance on the value of their funds dropping suddenly. However, Roddy Kohn, a financial adviser at Bristol- based Kohn Cougar, adds: "They also offer the chance of paying off a debt early, as long as investment performance is good."

A policy launched this week is intended to offer the tax benefits and flexibility of a PEP with the safer approach of a unit-linked endowment. Legal & General says its PEP with life cover attached is cheaper than most equivalent endowments, bearing in mind similar investment returns after tax, as shown in the tables.

But, as Roddy Kohn says, "the arguments are not entirely fair because they are not comparing like with like. It is easy to find a PEP and life cover that are much cheaper together than L&G's."

To the company's argument that it offers ease and convenience, he retorts: "Nonsense. Any independent financial adviser can come up with something better than this with just a few minutes' research."

Mr Kohn is a strong supporter of the pensions mortgage, where people make contributions into a personal pension and use the 25 per cent tax- free lump sum they receive at retirement to help pay off the loan.

He admits: "Some argue that you should not confuse pensions and mortgages and that the lump sum should be used for retirement purposes. But most people don't pay enough into their pension anyway. If you can tie the two together so that they are paying off their mortgage at the same time, so much the better."

He adds that in this instance, flexibility comes from alternative investment vehicles if contributions into a personal pension should stop for any reason.

His point is indirectly backed by Mr Darby, who says: "A lot of people think that there must be a specific savings policy to go with an interest- only mortgage. But, in fact, many mortgages are paid off in all sorts of ways, including redundancy payments, inheritance and so on. All these are valid ways of paying off your loan."

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