A key decision: which type of mortgage?

A bewildering variety of packages are on offer, and their pros and cons can be difficult to fathom. Tony Lyons explains
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There are many different types of mortgage available to home-buyers today - but not all of them are suitable for everyone. Your choice of mortgage should match your personal circumstances now - and realistic prospects for the future.

It pays to know how the different types of mortgage work - so that if you enquire about one and are offered another you can understand whether or not it would be suitable.

Sales staff will stress the good points of a particular product - but (to put it charitably) may be less clear about their disadvantages. So here they are:

Repayment mortgage: the traditional form of loan, which repays both capital and interest over a number of years. You should take out low-cost life assurance that will repay the loan if you die before it is paid off. This type of mortgage is not portable, so a completely new arrangement will be needed every time you move house. The other drawback is that the monthly payments go up or down when the mortgage rate changes.

Interest-only mortgages: you pay only the interest on the loan. At the end of the mortgage term, the capital has to be repaid, which can be out of an inheritance, the sale of the house or by any other means. The borrower needs to make sure that the sum will be available at the due time.

With-profits endowment mortgages: one of the most expensive ways of buying a home. Interest payments are made on the loan and premiums are paid into a with-profits life assurance policy. The capital is repaid out of the maturity value of the policy at the end of the mortgage or on death, if earlier. The hope is that the pay-out will be much more than the value of the loan, leaving a sizeable capital gain. But beware: all endowment policies will give a poor return if surrendered early. Existing endowment policies - including those taken out for previous home loans - can be "recycled" if you move or remortgage - so do not be talked into taking out a new one unless you are increasing your borrowing. In which case you should consider an additional policy for the difference, rather than the whole amount of the loan.

Cheaper methods than full with-profits endowments are available - but you should look carefully at the terms.

Low-start endowments: these have premiums at a reduced rate which gradually increase, usually over five years, making it easier to budget in the early days. You could find that after five years, you are paying more than with a conventional policy.

Low-cost endowments: these depend on bonuses being maintained to repay the capital. The insurance company usually estimates that it will pay at least 80 per cent of its current bonus rate throughout the term of the policy, to make full repayment with the hope that there will be a small cash surplus for the borrower.

All endowment mortgages are portable and can be moved from home to home. Their main disadvantage is they depend on bonus rates being maintained. In the 1980s some three-quarters of all home loans were endowment mortgages. Recently life assurance companies have been reducing bonus rates, because returns on their investments have fallen as inflation rates have come down.

Some borrowers have already been warned that plans which they took out 10 years ago, especially low-cost endowment mortgages, may have to be topped up - otherwise the proceeds at maturity may not be enough to repay the capital.

Unit-linked endowments: a variant on with-profits endowments, with premiums going into an investment fund. The problem is that unit prices can go down as well as up and as all investors should know, past performance is not necessarily a guide to the future. If equity prices rise long term it may prove possible to repay the mortgage earlier than planned - but there is no guarantee.

PEP mortgages: interest-only mortgages with capital repaid from a series of PEP plans. While the rules governing PEPs have to be adhered to, this is a highly tax-efficient method of paying a home loan. Like all equity investments, final value is dependent on share prices, which go up and down. But if the PEPs do well, a mortgage can be paid early.

Pension mortgages: only available to those who can take out personal pensions. Interest is paid monthly while premiums go into a personal pension plan. The capital is repaid out of the facility at retirement to commute up to 25 per cent of the pension into cash. Borrowers get full tax relief on premiums, so it is a highly efficient means of paying a mortgage - even if many personal pensions carry high charge structures.

Remember that this will take a lot, if not all, of the capital available from the plan at maturity, which will mean a reduced retirement income. Also, if investment is in a unit-linked fund, there are no guarantees of the plan's final value - as units can go down in value as well as up n

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