Mortgages Guide | Mortgage Help Product Information

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Introduction

Endowments are still the most popular form of investment used to pay back an interest only mortgage. They are essentially an investment product designed to generate sufficient funds to pay back the loan at the end of the term, or earlier if you die.

As with other interest-only mortgages, you pay interest to the lender on the full amount of the capital for the entire duration of the loan term. The remainder of your monthly payment goes towards a premium for an endowment policy.

A portion of this premium is invested into some form of fund that is eventually used to pay off the capital owed to the lender. At the beginning of the policy, the provider will make some assumptions about the growth rate of the investment. There are often a variety of different assumed rates of growth for you to choose from. The rate is used to calculate how much your repayments need to have enough money to repay the loan at the end of the term.

Whether or not your repayments will actually be enough to reach the level of your loan is not normally guaranteed. However, with good fortune and skilled management, hopefully the investment will grow faster than the projections used when the loan was taken out, thereby leaving you with a cash lump sum at the end of the term.

The size of the premium is affected by the growth rate by which your fund is expected to grow. The higher the assumed growth rate, the cheaper the premium - you are relying more on favourable market conditions and the prudent investment skills of the fund managers than on the amount of money you pay in. However, a higher assumed rate of growth brings a greater risk that the investment objectives will not be reached.

If the assumption is that the growth will be slower, your premiums will be more expensive, as you must contribute more money to compensate for the 'probable' inferior rate of growth. But to compensate, this brings a greater likelihood that your fund will exceed the performance necessary to repay the loan at the end of the term. If this is the case, then there will be a cash surplus left over, which you can keep - with no tax to pay! Given the experience of the last decade, which has seen some advisers underestimate the amount of funds needed to generate sufficient money at the end of the term, it is probably always best to err on the side of caution.

Not all of the premium goes towards the investment side of things, as a portion of your monthly payment is used to pay for a life assurance policy that is designed to ensure the full amount of the loan is repaid if you don't survive to the end of the repayment term. Life insurance is an integral part of the endowment product, not an optional extra. You cannot have an endowment without the life assurance element. If you really don't want to pay for life cover, don't get an endowment.

With an endowment policy, the length of the repayment term is fixed and cannot usually be altered. You can take the endowment with you if you move to a new home, though you may need to top up the payments if you add additional borrowing to your mortgage. You can keep on raising the amount you pay into it each time you trade up to a more expensive house. You are not usually required to show any further evidence of health to increase the cover on the life assurance element of the endowment.

Another useful facility, which can generally be arranged as part of the endowment, is a waiver of premium. This is the option to have your premiums paid by the life office in the event that you cannot work because of illness or accident. It works very much like an income protection policy. This does not come as standard with an endowment and costs extra.

There are various different types of endowment, the main types of which are summarised below.

With Profit

The most expensive of all the endowment plans, full with profit endowments have the highest guaranteed returns, but is being offered less and less by UK life insurance companies.

This type of endowment guarantees an annual growth rate and also guarantees to pay off the full loan at maturity. This is the only type of endowment that offers this guarantee, which is the cause of the added expense.

At the outset, some assumptions are made about the future growth rate of your investment. These assumptions govern the size of the premiums that you will pay into the fund.

Part of the premium with a full with profit endowment is used to pay for the built-in life insurance cover. The life insurance element ensures that the endowment policy will have a guaranteed death benefit, which will be for the same value as the mortgage, thereby ensuring that the debt will be paid off even if you die.

The portion of your premium that is being invested is pooled with the premiums of other investors. These are then paid into a fund managed by the life company.

Annual bonuses are added to the maturity value each year. The size of these bonuses depends partly on the performance of the investment fund, so in a sense you are sharing in the profits of the company. Once added, these bonuses cannot be taken away.

There is also a final bonus that depends partly on the performance of the fund over the entire term. The terminal bonus may represent a large portion of payout and is guaranteed to be at least enough to repay the loan.

There is a possibility that the bonuses will take the maturity value above the level required to pay back the loan. This would result in a tax-free cash surplus, which you can spend on whatever tickles your fancy.

The maturity value grows throughout the life of the policy. The large size of the final or terminal bonus makes it rare to be able to cash in this type of endowment policy early without losing out and if you do so, you may well end up getting back less than you put in.

Low Cost

This is perhaps the most popular type of endowment with mortgage borrowers and it shares many features of a full with-profit endowment:

  • Future growth in the value of the investment element is assumed to be at a certain rate and this rate is used to determine your necessary repayments.
  • Your premiums are pooled with those of other investors and paid into a fund managed by the life company.
  • Annual bonuses are paid which cannot be taken away (hence it still being called a with-profit endowment)
  • A terminal bonus is paid that may represent a large portion of the final payout.
  • There is a possibility of cash surplus at the end of the term.
  • It has built in life assurance to cover the value of the loan.

There are some key differences though:

  • A full with-profit endowment guarantees that the maturity value and death benefit will be sufficient to repay the loan. However, although low-cost with profit endowments also have a guaranteed death benefit and guaranteed maturity value, these start as only a portion of the loan amount, offering no certainty that the investment will ever be sufficient to repay the loan. This lack of guarantee means your monthly premiums are lower than they would be for full with-profits endowment.
  • The policy value will rise during the course of the term as the annual (also known as reversionary) bonuses are added to the guaranteed maturity value each year, though there is no guarantee that this will be enough to pay off the full loan.
  • The terminal bonus is not guaranteed to take the maturity value to the level needed to pay back the loan. It may well take the value a lot higher, but there is no guarantee.
  • If profits were less than expected, you would have to find funds to cover the outstanding balance at the end of the term. In practice this rarely happens if the assumptions made at the opening of the policy are prudent, though there has been a much-publicised epidemic of cases where customers are advised during term that the investment performance is not on course to reach the required level. Often, the best thing to do if possible is to increase payments and put the investment back on track, though some people decide to cut their losses and either cash in their endowment or sell it on the traded endowment (TEP) market.

Unit Linked

Unit-linked endowment policies were specifically designed for use with mortgage repayment and are being offered by life offices more and more. They differ quite substantially from with-profit endowments in the way they work but also carry a reasonable degree of risk:

  • As with other endowments, you still make interest payments on the full value of the loan. However, you are not locked in to this type of endowment by annual and terminal bonuses. Instead, the borrower is able to cash in the policy and repay the mortgage as soon as the investment element has accumulated enough to repay the whole mortgage amount.
  • Your premiums are used to buy units in a managed fund at the prevailing market price. An assumed rate of growth for the value of the units is used to predict a necessary level for your monthly repayments. The number of units you hold increases over time as more and more premiums are paid. The value of these units can fluctuate in line with the investment performance of the fund.
  • Not all the premium goes towards investing and units. Some of the units are cashed in to buy life cover. As with other endowments, the life insurance element is there to ensure that the full loan can be repaid if you die. With this type of endowment, however, the level of cover required fluctuates depending on the value of the units. The amount of cover required is the guaranteed death sum assured (amount needed to repay the loan) minus the current surrender value of the policy. As the policy value rises, the amount of life cover (and therefore the amount of your premium needed to purchase it) decreases.
  • There is no guaranteed annual growth rate caused by the additional of annual reversionary bonuses. In a year of poor investment performance, the value of your endowment may drop considerably. Equally, in a successful year, the value of your unit holding may rise dramatically. This means that a unit-linked policy has both the potential for greater, faster growth than a with-profits endowment and a greater risk of failure to meet investment objectives.
  • Providers differ in the percentage of your premium that is used to buy units. Whatever percentage is used, it will take a few years for your premiums to start buying any significant volumes of units - charges and commission payments eat up much of the premium in the first few years. Once you have built up a significant volume of units, you will start to receive an annual unit allocation statement showing your holding of units and their current bid price, or how much you can sell them for. This means that it is possible to gauge exactly how much the policy is worth at any point in time.
  • The investment performance of the fund is reviewed at set intervals and the level of your payments can be altered accordingly. Unlike other types of endowment, a unit-linked policy can allow you to pay off the loan early. Since there are no bonuses to be added during the course of the term or at the maturity date, the encashment value of your units at any point in time is the value of your policy. If this reaches the value of your loan, you can cash it in and repay the loan.

Unitised with profit endowment

This is a hybrid unit-linked endowment, designed to smooth out price fluctuations that occur with unit-linked policies. The value of units is declared each year and that value is then guaranteed. The guaranteed value that is declared is at a discount to the actual value of the units. The guaranteed value will not reach the real value until the term of the endowment is up, so the chance of being able to pay of the loan early is minimised. This type of endowment is becoming increasingly common, especially due to the volatility that has been displayed by the stock market over the last year or so.

Low-start endowment

This is essentially the same as a low-cost with profit endowment, but premiums begin at a lower level and gradually increase over a number of years - usually between five and ten. The initial premium can be significantly lower than the full premium, but never lower than half (which is a common starting point). Premiums may, for example, increase from 50% to 100% of the final value by 20% per year for 5 years or by 10% per year for ten years.

This is another product designed to make it easier to budget over the first few years of home ownership, when money is likely to be tighter for many people. As with most products that work this way, you generally have to pay for it in the long run. The overall level of premiums you pay will be higher than with a low-cost endowment, and the cash-in value will be lower for longer. You are likely to be seriously out of pocket if you try to cash in your low-start endowment much before maturity.

Non-profit

The guaranteed death benefit or sum assured equals the value of the mortgage loan, which guarantees repayment of the loan if you die. There are no annual or final bonuses and you therefore have no chance of a cash surplus on maturity. Essentially, there is no real benefit to this type of policy other than inclusive life cover. Non-profit endowments are generally seen as an inefficient method of saving the money to pay back a mortgage and are therefore rarely used for such a purpose.

Endowment Advantages

Aside from the general points that relate to most interest-only products, there are a few added features of endowment mortgages which may influence your decision on whether to use one as a repayment vehicle for your mortgage. Not all these sadvantages will necessarily apply to every single type of endowment policy in all circumstances. Always check the policy literature, ask the life company or consult an expert if you are in any doubt.

If your policy grows at a faster rate than was assumed when it was taken out, you should end up with a cash surplus at the end of the repayment term. This surplus is yours to keep and is free of tax. You may also be able to pay off your mortgage early, depending on the endowment type.

Life insurance is an integral part of the product, a fact which can bring two advantages: Peace of mind that your mortgage will be fully paid off if you die during the term and the fact that you do not need to worry about arranging life insurance to cover your mortgage loan separately. You can sometimes integrate income protection with endowment policies as well, in the form of a waiver of premium, although you may still feel it is necessary to take out an additional protection policy to protect your interest payments.

During periods of low interest rates, a greater portion of your fixed monthly payment is going into your endowment policy, as your interest charges will be lower. This increases the likelihood of there being a surplus at the end of the mortgage term. This means that endowments can be more attractive when base rates are likely to fall in the future.

If you do stop your payments into the endowment, then your policy value may still increase, as the underlying fund should still be growing. Unfortunately, this will not be nearly as fast as it would be under normal circumstances because:

  • No further payments are adding to the total
  • Investments grow cumulatively - the more there is, the faster it should grow
  • Management charges are deducted from the fund, reducing your growth

Endowment policies are portable. You can take the endowment with you if you move to a new home, though you may need to top up the payments if you add additional borrowing to your mortgage. The term of new mortgage does not have to extend beyond the original endowment, so you could end up clearing your overall mortgage debt quicker than with a series of repayment mortgages.

Endowment Disadvantages

Aside from the general points that relate to most interest-only products, there are a few added features of endowment mortgages which may influence your decision on whether to use one as a repayment vehicle for your mortgage. Not all these disadvantages will necessarily apply to every single type of endowment policy in all circumstances. Always check the policy literature, ask the life company or consult an expert if you are in any doubt.

There is a very real risk that the fund will not perform well enough to cover the capital lent to you for your mortgage. Most endowments that are used to repay mortgages will not guarantee that you will not be left with a shortfall. The size of your fund is largely dependent on your insurance company's ability to invest.

Many endowment holders have hit trouble over the last few years due to falls in stock markets that have impacted the equities into which both unit linked and with-profits endowment funds are invested.

As a result, some companies have been announced severe cuts in the payout values of maturing policies by way of reductions in the final bonus rates for most with profits policies. Unit linked policies are affected more directly by the stock markets as the value of the fund in which units are bought has been hit by reductions in the equities into which the fund is invested. During periods of high interest rates, a large portion of your monthly repayment is taken up with interest. This may mean that less is being paid into your endowment than is necessary to meet the investment objective.

Advisers get whopping great commissions from the sale of endowments. This can be anything up to £1500, so the unscrupulous amongst them may push for you to buy one even if it is not the most appropriate product.

One of the reasons that the lenders can afford to be so generous is because endowments are relatively inflexible. You can pay heavily if you wish to cash in the policy before it has finished its term, which means that the lenders generally enjoy your custom for many years. The earlier you try to cash in, the worse the charges in comparison to what has been paid in. You may not get back as much as you have paid out.

There are higher set up costs, charges, administration costs and commission payments in the early years than there is with a repayment mortgage. These are hidden within the monthly premiums. You should always find out what the charges are and check past performance, not forgetting that this is no guarantee of future investment performance.

Endowments are heavily 'front-end loaded', which means that they may have little or no cash-in value for the first few years of the term. This is because as much as a third or more of your premium can be taken up paying introducer, administration and management fees during the first few years or so. It is only once these charges have been paid for that the value starts to accrue more quickly, boosted (depending on the type of endowment) by annual bonuses being added to the policy value.

With the exception of unit-linked endowments, it is normally impossible to extend the term of the endowment policy. This can limit the value of any property you can move to, unless you wish to take out additional investment products. With a repayment loan, you can stretch out payments to cope with increased borrowing, with an endowment you can only raise the payments and there is likely to be a limit on how much you can afford.

You have to have life cover as it is built in to the product. Some people may have no dependents and enough assets to pay off the loan and may therefore have no requirement for life assurance.

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