Match your needs to meet the debt

Richard Miles explains the various options for repaying a mortgage and lists the pitfalls
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The Independent Online
BUYING a house is the biggest financial commitment most people make, so it is vital to choose the right way to pay for it.

Until the mid-1970s prospective borrowers had little choice. Only one type of mortgage was on offer, traditional repayment loans, and most building societies would lend only to people who had saved with them for some time. Twenty years on borrowers are faced with a confusing array of mortgages and ways to repay.

Selecting a repayment method that suits your circumstances can make a huge difference. It is a good idea to have a reasonable understanding of the products on offer before you talk to your mortgage broker or building society manager.

The traditional way to repay is through the capital and interest or repayment mortgage. The borrower pays off a portion of the outstanding debt plus interest on the mortgage each month.

A repayment is the safest type of mortgage. It is ideal for people who view their property as a home and not as an investment. So long as you keep up the payments the loan is guaranteed to be paid off at the end of the mortgage term, traditionally 25 years. If you have a family you should take out straightforward life insurance, known as term insurance, to pay off the loan should you die before you have completed the mortgage term. Some lenders will make this a requirement for lending money. You may also want to consider critical illness insurance, which pays out a lump sum if you develop a serious illness.

The one disadvantage to repayment loans is that you have to take out a new mortgage each time you move house. If the mortgage is less than five years old little capital will have been repaid and the borrower will in effect be starting from scratch if he or she moves house.

Most new borrowers opt for an endowment mortgage. With this type of mortgage you have a loan on which you pay only interest, and you make a separate payment every month into a savings plan called an endowment policy. Endowment policies are run by insurance companies and combine savings with life insurance, so you will not need separate life insurance on top. At maturity, typically 25 years, the endowment should have grown sufficiently to repay the capital and maybe provide an additional lump sum.

The traditional type of endowment is termed with-profits. The policy's growth is not directly linked to the stock market. It smooths out any fluctuations in the market's performance to ensure steady returns and its big plus is it cannot fall in value. The returns are paid in the form of an annual bonus. As the insurance company errs on the cautious side it passes on any extra investment performance by paying a terminal bonus at the end of the policy's life.

Unit-linked endowments are more risky. The underlying fund's performance is tied directly to the performance of the stock market. Each premium buys a set of units representing the underlying investments of the fund. Your final payout reflects the value of these units at the policy's maturity date.

An endowment can be carried from one house to another and can be topped up. In emergencies you can stop payments into the endowment, sell it to someone else, or surrender the policy to the insurer in return for a cash payment. However, there is no guarantee that an endowment will produce a high enough return to pay off the mortgage. Some insurance companies have asked investors to increase their premiums because investment performance has been so poor. You will also be penalised financially , sometimes severely, if you surrender the policy early. Higher rate taxpayers will face a tax- charge if they surrender within the first 10 years.

An increasing number of home buyers are using personal equity plans to repay mortgages. Endowments have become tarred as inflexible, poor value and as being sold for their high commission rather than their appropriateness.

The PEP mortgage is more tax-efficient. Like the endowment mortgage you simply pay off the interest on your loan each month. But you invest the rest of your premium in a unit-trust or investment trust PEP. Any gains on the PEP are free of income and capital gains tax. An endowment attracts tax as it grows.

In theory the tax breaks for PEPs should permit an investment to grow that much faster, increasing the chances of being able to pay off the loan early, or obtaining a surplus lump sum at the end of the mortgage's term. PEPs are also very flexible. Most plans will allow you to increase, reduce or suspend payments altogether without any penalty. You can also cash in part of your savings at any time should you need money in a hurry.

A significant drawback to PEP mortgages is the risk. Your investment may fail to grow at a sufficient pace to repay the capital. It may even fall in value. Life insurance is also an extra cost.

The most tax-efficient way to repay a home loan is through a pension. But pension mortgages are suitable only for long-term borrowers with a stable income. Again, you only pay off the interest on the loan, while the capital is repaid by the tax-free portion of your pension fund on retirement.

One final option is an interest-only mortgage. Here you do not bother with a repayment vehicle, at least initially. You might look to pay off the loan with a future windfall, helped by any profits on selling and by inflation eating into the real value of the debt. Lenders, predictably enough, are less keen on offering this type of mortgage. But for borrowers it is the cheapest mortgage option. You simply pay the interest and, perhaps, a term assurance premium.

The figures in the table give an idea of costs .While pension mortgages are the most tax-efficient, they have the highest premiums. You will end up with a house and a pension but when you are starting off and money is tight, pension planning may not be a priority.

Comparative cost of mortgage repayment methods

pounds 60,000 loan over 25 years. Male aged 30, non-smoker, basic-rate taxpayer

Mortgage rate: 7.5 per cent

Repayment

Payment to lender pounds 420.44

Term assurance premium pounds 18.47

Total pounds 438.91

Endowment

Payment to lender pounds 346.88

Endowment premium pounds 98.64

Total pounds 445.52

Pep

Payment to lender pounds 346.88

Pep premium plus life cover pounds 95.72

Total pounds 442.60

Pension

Payment to lender pounds 346.88

Pension premium plus life cover pounds 206.70

Total pounds 553.58

Mortgage rate: 10 per cent

Repayment

Payment to lender pounds 513.34

Term assurance premium pounds 18.47

Total pounds 531.81

Endowment

Payment to lender pounds 462.50

Endowment premium pounds 98.64

Total pounds 561.14

Pep

Payment to lender pounds 462.50

Pep premium plus life cover pounds 95.72

Total pounds 558.22

Pension

Payment to lender pounds 462.50

Pension premium plus life cover pounds 206.70

Total pounds 669.20

Source: Halifax Building Society

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