Mortgages Guide | Mortgage Help Product Information

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Introduction

ISAs were brought in to replace PEPs as the mainstream tax-free savings vehicle. They take a variety of formats: you keep hold your money in cash, life assurance policies such as endowments, or stock market based investments such as shares, unit trusts, investment trusts and investment bonds, or even a combination of the different holdings. Only a very small percentage of the mortgage market involves interest-only mortgages coupled with an ISA.

As is normal for all the interest-only repayment methods, you pay interest on the full amount of the loan for the full duration of the term. You also pay an agreed monthly sum in addition to your interest repayments. With this type of mortgage, your payments go into the tax-free ISA savings vehicle. The value of your investment hopefully accumulates over time and any growth is added to your balance free of tax.

The monthly payment sum is normally calculated using an assumed growth rate for your ISA plan. However, ISAs are a bit more flexible than many investment vehicles. With an ISA mortgage there is not always any fixed term for the plan. As long as you are keep on making your monthly repayments, some lenders will let an ISA run until it has built up enough to repay the loan.

If your ISA performs well, you may be able to repay your loan well in advance of the planned end of term. You can often help the chances of this happening by paying an annual lump sum instead of monthly instalments. Depositing a full-year's worth of instalments into the ISA vehicle at the start of each year means that the investment should grow more quickly over time - the sooner you make a deposit, the sooner it can start growing.

You can usually arrange insurance to cover your investment contributions in the event you cannot pay due to accident, disability, redundancy, death, critical illness or any of the other phenomena usually covered by protection products. You may also require separate life insurance to ensure that the loan can be repaid if you die before it is paid off.

Organising Your ISA

An ISA is not an investment itself, but a wrapper in which other investments can be held tax -free. The returns on these investments are free of income tax and capital gains tax but there are limits to how much money you can pay in each tax year.

The maximum total investment each year in an ISA is £7000 per person, with no lifetime limit on the total amount that can be invested. Each year, this money can be comprised of different elements, stocks and shares, cash or life insurance as set out below:

  • Maxi ISA - A Maxi ISA has an annual limit of £7000. This can be all stocks and shares or it can be a combination of the different elements, all held under one umbrella. The maximum contribution of cash is £3000 and the maximum contribution of life insurance is £1000
  • Mini ISA - Mini ISAs are essentially the component parts of a Maxi ISA in isolation, with the main difference being that the maximum value of a stocks and shares Mini ISA is £3000. You can have up to one of each different type of Mini ISA and the maximum you can invest in a Mini Cash or Mini Life ISA is £3000 and £1000 respectively. The advantage of a Mini ISA over a Maxi ISA is that you can have different providers for each element, thereby allowing you to choose providers that specialise in one particular element.

The different components are life insurance, cash, stocks and shares:

  • Life insurance - The life insurance element is invested in life insurance-linked investment products such as life-company with-profit bonds. Plans must be single premium contracts that can accept a single lump sum deposit.
  • Cash - Cash can be held on deposit, for instance in a normal savings account or a money market unit trust that pools investors' money and spreads it across a range of deposits on the wholesale money markets. Cash ISAs are available through banks, building societies and even the post office.
  • Stocks and shares - This ISA element allows you to invest in a wide range of holdings. They are most suitable for medium to long term investors who are looking for capital growth, higher tax free income or a combination of the two. You can invest in ordinary shares, preference shares, convertible shares, corporate bonds, UK governance gilts and managed collective funds (such unit trusts, OEICS, investment trusts and offshore funds) in any registered stock market in the world. This is the most popular type of ISA investment.

With all this in mind, there are two ways in which you can organise an ISA repayment vehicle - either create a personal portfolio of ISA investments or choose an existing ISA mortgage package, which comes with an in-built mechanism to monitor performance.

The latter option used to be quite popular, but the volatility of the stock markets has led to far fewer people taking up interest only mortgages in general, with a knock-on effect on the popularity of the ISA mortgages. So much so that the volume of business that most lenders were completing in the fairly niche market of ISA-linked mortgages has been insufficient for most of them to maintain their ISA mortgage products.

You will therefore have to choose your own ISA products and either invest in funds or purchase investment products to be held within the ISA wrapper. This is quite a difficult task and is something that even highly paid professional investors don't always get right. You are well advised to think seriously about whether or not you want to take on what is a substantial risk and should probably seek out independent financial advice unless you are certain that it is the route you would like to go down.

Advantages of an ISA

Aside from the general points that relate to most interest-only products, there are a few added features of ISA mortgages which may influence your decision on whether to use one as a repayment vehicle for your mortgage.

At the same level of contributions, an ISA should provide a higher return than an endowment because of the tax advantages. This happens for two reasons - firstly because none of the monthly payment is going towards a life insurance policy and secondly because any gains that the ISA fund makes are added back to the fund free of tax.

Less of your monthly payments are being eaten up with set up or maintenance charges and commission payments than with endowments or pensions. The exit penalties if you wish to switch to another method of repaying your mortgage may therefore not be as harsh. Don't take that for granted though, always check the details of your policy documents before you rush in and do anything.

With an ISA, you get to choose an investment format that suits your attitude to risk. If you are conservative and have a sufficiently small loan, you could keep all your money in cash,. Although this often a less efficient long-term way of paying back your loan than a stocks and shares ISA, it does carry far less risk.

ISAs are more flexible than endowment policies:

  • The length of the term is more variable.
  • The payment structure can be tailored to suit your circumstances - if you have quarterly or annual bonus, you can deposit this into your ISA immediately and start accumulating extra investment gains right away.
  • You can take money out of the ISA during the life of the loan, pay off some of your mortgage balance and reduce your interest payments. This may affect the speed at which the investment grows, as a smaller investment fund will take longer to grow.
  • You can usually arrange for payment holiday, though if your investments fall behind plan, bear in mind that it can be difficult to get them back on track
  • It is usually easier to switch providers with an ISA than it is with an endowment or pension.

Disadvantages of an ISA

Aside from the general points that relate to most interest-only products, there are a few added features of ISA mortgages which may influence your decision on whether to use one as a repayment vehicle for your mortgage.

The limits on your annual contributions can make it difficult to pay back your loan. These limits are currently set at £7000, so you would have to rely on good investment performance to repay a loan of over £250,000 within a twenty-five year period. You can invest more than your individual ISA contribution limit, but anything over the limit will be outside the tax-free wrapper. This is less of an issue for couples, as they are each allowed to invest their individual maximum, making an annual ceiling on the total investment of £14,000. Unfortunately, it is not normally possible for these funds to be held together in order to accumulate at a faster rate.

ISAs are only guaranteed to exist until April 2009. If they are replaced, you will have to find an alternative investment or savings scheme.

You face the risk of stock market fluctuations if you are using a stock market linked ISA. The estimated growth rates used at the start of the plan may be quite inaccurate and there is a good possibility that it may take longer than planned to pay back your mortgage if your investment does not perform as well as planned. Tax-free savings are great in theory, but where an ISA is equity-linked it's not so great when the value of the investment is actually falling. This problem can be alleviated to some extent by using an ISA that buys into investment bonds, which generally provide a more predictable investment return.

You are slightly vulnerable to poor investment decisions by the managers who run the ISA. Always check out the past performance of the ISA provider, but remember the much-vaunted saying 'past performance is not necessarily a guide to future returns and the value of your investment can go down as well as up'. Tying your mortgage to an ISA uses up your tax-free savings allowance. If you are a high earner that pays the highest rate of tax, then you may wish to keep this allowance free for other purposes.

If you are planning to set up your own portfolio of investments, you should be aware that there is no guarantee that they will perform sufficiently well to pay off mortgage debt. Self-management requires a strong knowledge of how the markets work, making this a very high -risk strategy for mortgage repayment, suitable for only a very small minority.

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