Capital & Interest or Repayment Mortgage is the traditional, no risk method of repaying a mortgage.
Payments to the lender are made up of capital (this element reduces the debt) and interest (a charge that the lender makes against the money you owe to them).
Payments are designed to remain the same throughout the mortgage term, assuming there is no change in the interest rate, amount borrowed or mortgage term.
Interest Only Mortgages
The payment to the lender for an interest only mortgages is less than a repayment mortgage because no repayment of capital takes place during the mortgage term – this means you will always owe what you originally borrowed. You will need a means of repaying the mortgage at the end of the term, the cost of this combined with the interest payments will be similar to a repayment mortgage.
Only a few lenders offer pure interest only mortgages – i.e. when you do not have to have a repayment vehicle in place to repay the mortgage. You will generally pay a higher rate of interest for such mortgages.
Savings plans running alongside interest only mortgages that are acceptable to lenders…
- ISA’s (Individual Savings Plans) which are flexible and tax efficient
- Pensions, although you have to pay a lot because only 25% of the fund can provide a lump sum capable of repaying the mortgage
- Endowments, although these have suffered a lot of bad press because of their inflexible structure, high charges and lack of tax efficiency – life cover is included though.
You can work out how much you will have to save to repay your mortgage by clicking o the calculator links
Endowments are investments that are designed to repay a mortgage at the end of the mortgage term and included life assurance that would repay the mortgage in the event of death andor critical illness. They were very popular until the mid to late 90’s.
During the mid 90’s inflation began to fall significantly and this led to lower investment returns. Most endowments were designed to repay a mortgage if the investment return averaged 9%-10%pa, this was overoptimistic during periods of low inflation.
To overcome lower investment returns policyholders would be required to increase their contributions but this was not palatable to many people when other investments like PEP’s and ISA’s looked better value in terms of historical performance and more favourable tax treatment. Better still was the traditional method of repaying a mortgage (capital & interest method) which carried no risk.
When the stock market crashed during 2000 many life assurance companies cut back their bonuses on endowments linked to With Profits funds. This compounded the problems when life assurance companies provided their policyholders with performance projections. This led to the demise of the endowment policy after many successful years of repaying mortgages.
If you want to consider an investment to repay your mortgage then an ISA or Pension may offer better prospects than an endowment.
Legislation allows a pension fund to provide up to 25% of its value as a tax free lump sum, it is this which is used to repay your mortgage. The remainder must be used to provide an income in retirement. Tax relief is allowed on pension contributions, so depending on your tax rate a £100 contribution will only cost £80 for a basic rate tax payer or £60 for a higher rate tax payer
What is an ISA mortgage?
ISA; Individual Savings Account – a tax efficient savings plan in which you can save a maximum of £7,200 each year. You can choose to invest your savings in a wide range of investments ranging from zero risk (building society accounts) to high risk (shares in companies). A low risk approach is consistent with a lower, steadier rate of return. Conversely, higher risk may return higher rewards but the journey could be quite rocky.
When using an ISA to repay a mortgage you will only pay interest to the lender, therefore you will always owe the original amount borrowed and it is the ISA that is used to repay the mortgage at some point in the future, this could be sooner or later than expected depending on how well your investment performs.
Most people have some savings and a current account. Offset accounts combine the mortgage with your savings. To maximise the savings you could choose to operate your current account with the lender although this is not necessary with all offset mortgages. Your earnings would be paid in and all your direct debits paid out. Instead of earning interest on your credit balances, the lender deducts this from the mortgage interest. Since interest is “saved” rather than “earned” there is the extra benefit of no tax paid on the savings Overpayments that you make are always accessible.
Many people use these accounts to set aside funds to settle a tax bill or simply save for other expenditure like a car, holiday or school fees. Typically, you can choose to maintain your normal monthly payment and ‘overpay’ each month – this effectively reduces the mortgage term. Alternatively, you can request to keep the mortgage term the same and your monthly payments will reduce. These accounts normally calculate the interest owed daily. Which means that every £1 invested is working hard to reduce the overall cost of the mortgage. For example, if you have a mortgage of £150,000 and savings of £15,000, you will only pay interest on £135,000.