If you choose an interest only mortgage you will also need to arrange a repayment method to pay back the capital at the end of the mortgage. There are a number of different options available, including an endowment or a pension or an ISA.
With an endowment mortgage you make your monthly repayments of interest to the lender and as well as this, you make contributions to an insurance company to fund a savings plan. This savings plan aims to generate sufficient funds to pay off the capital at the end of your agreed mortgage term.
The savings plan can be “with profits”, “unit-linked” or a combination of them both.
“With profits” policies pays two types of bonuses. A “reversionary” bonus is usually paid into the savings plan each year and, once awarded, is usually guaranteed provided the policy is still active on the maturity date. A “terminal” bonus is awarded on the policy maturity date and its size will depend on the performance of the fund over the lifetime of the policy.
With “unit-linked policies”, the value is driven by the underlying value of the investments when the policy reaches maturity (but you can often swap into safer investments a few years earlier if you wish). If you die before the term is complete, the life insurance aspect of the endowment policy is used to clear the loan.
The good thing about an endowment repayment vehicle is that you can maintain the policy if you move house or change mortgage provider. Endowments can include some kind of life and critical illness cover which is usually cheaper than buying such cover separately. If the underlying investments perform well, you may get more than is needed to pay off the loan.
But if the underlying investment performs poorly, you could end up having to review the premium subscriptions to your endowment policy and/or the basis on which your mortgage is operated in order to ensure that the mortgage loan can still be repaid in full at the end of the agreed term.
With a pension repayment vehicle, you make your monthly repayments of interest to the lender and you also make contributions to a personal pension. This personal pension then provides a tax-free lump sum as well as a taxed regular income at retirement. Most, if not all, of the lump sum is used to clear your mortgage loan at that date.
On the good side, pension contributions qualify for tax relief of up to 40% (for a higher rate taxpayer), which boosts the value of every pound you contribute to your pension.
However, using your tax-free lump sum as a mortgage repayment vehicle may leave you with inadequate income in retirement. Also, the lump sum is payable on retirement, so your loan term may be more than 25 years (depending on how old you are and when you are planning to retire!). The biggest problem is that poor performance could adversely affect the amount of the tax-free lump sum resulting in insufficient funds available to repay the loan at the end of the agreed term.
Using an ISA as a repayment vehicle, you make your monthly repayments of interest to the lender and you also make contributions to an Individual Savings Account (ISA). Like the PEP mortgages which preceded them, ISA mortgages use stock market-based investments for tax-free growth.
There are two main types of ISA: “mini” and “maxi”. There are different rules over contribution levels and range of investments available in each.
On the plus side, if your ISA performs well, you may be able to pay off your mortgage early.
However, a stock market crash could leave your investment in trouble. Also, current tax rules dictate that the maximum investment in an ISA is £7,000 per annum, which won’t be enough to give you confidence that you will be able to repay a large mortgage at the end of the term.