Endowment or Repayment? A beginners guide! (General Comments)

Member Name: oxfordbloke

Product:	General Comments
Date:	09/07/01 (1628 review reads)
Rating:

Advantages: Endowments can be cheaper

Disadvantages: But, they are uncertain

This op explains the differences between endowment mortgages and repayment mortgages. It does not aim to recommend one over the other, simply to ensure a clear understanding so that a fair and rational decision can be made.

This op is necessarily long, but hopefully valuable.


First I will explain the key features of repayment and endowment mortgages, then cover the important differences. Finally, I will give some advice for use when making a choice between the two.


Note, for the moment i am assuming that interest rates never change. More on that later.


Repayment:
With a repayment mortgage your monthly payments are the same every month, but each payment has two elements, and these are constantly changing. First, there is the interest. At the start this is a huge amount. On top of this is a small amount that pays off part of the loan. The next year you owe slightly less, so the interest part of the loan falls slightly. This means that more of the payment goes towards reducing the loan. So another year later the loan has fallen by slightly more, the interest falls by slightly more, and again, slightly more goes towards reducing the loan.

Its a virtuous circle.

On a £50,000 loan at 6% interest, the payments are £325.94 a month. In year one the total payment is £3,911.34 (325.94 x 12). Of this £3,000.00 is interest and only £911.34 pays off the loan. In year 2 you pay the same amount, but this time only £2,945.32 is interest, and £966.02 goes towards reducing the loan.

By year 5 the interest is only £2,760.80 and the "capital" is £1,150.54, and in year 10, its £2,371.65 capital and £1,539.68 interest.

After that the interest element falls at an ever faster rate and therefore the capital element increases faster, meaning that the loan is accelerating towards zero. By year 20 the interest is only £1,154.00 - remember it was £3,000.00 in year 1.

At the
end of year 25, the loan is zero and you finally own your house.

Sorry if im getting a bit numerical, but trust me its worth it!

Okay, now for the alternative...


Endowment:
With an endowment mortgage there is a key difference. You do not repay any of the loan as you go along. Its worth repeating.

You do not repay any of the loan as you go along.

This means that the interest is the same every year (remember, we are assuming that interest rates stay the same). For this illustration we will assume that the return on investments is exactly the same as the interest rate on the repayment mortgage example - 6%. If this is the case, your monthly payments are exactly the same.

In year one you pay £3,911.34, just as you did with the repayment mortgage. The interest is £3,000.00 (thats £50,000 x 6%), and there is £911.34 left over.

This is invested for you.

In year 2, you the same thing happens. Another £911.34 is invested, but you already had £911.34 invested and this earns 6%, which is £54.68. So at the end of year 2 you have a total of £1,877.35 invested (£911.34 x 2 plus the return of £54.68).

In year 3 that £1,877.35 money earns a return of £112.64 and you add another £911.34 to it. And so it goes. The fund keeps growing due to both the extra £911.34 you put in every year, and the return on the investment.

By year 5 the return is £239.20 and the total fund is £5,137.29. By year 10 the return is £628.35 and the fund is £12,012.13.

The value of the fund accelerates as each year there is more money to earn a return on. In year 20 the return is an impressive £1,846. This is twice the amount that you are paying in yourself, so the money is really working on your behalf.

At the end of year 25 the fund is worth exactly £50,000. This is used to pay off the loan of £50,000, which stayed at the same value all along. And you own your home at last.
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So, there you have it. There is no difference between repayment and endowments.

At this point you say to me, "hang on, i thought there were some issues with endowments." Indeed. And here they are:


1. Rate of return

Investments earn a higher rate than normal interest rates in the long term.

Time to be repetitive again. IN THE LONG TERM.

Returns on investments vary all the time. The past couple of years have been a bit tought for stock markets and endowment investment could have actually shrunk, but over a period of 25 year, investments will almost certainly do better than normal interest rates.

Lets assume that investments earn 2% more than interest rates. In my example this would be 8%. In such a case the monthly payments no longer need to be £325.94. You will manage to amass the £50,000 paying only £306.99. Thats £18.95 less a month, or £5,684.92 over the full 25 years.

Seems like a bargain. Whats the catch?


2. Unpredictability

We are pretty sure that the endowment will earn a better rate than normal interest rates. But we dont know by how much.

If it is assumed that the endowment will earn 2% more, your payments will be £306.99, but nothing is guaranteed, and looking ahead 25 years is quite tricky.

When you take out the policy, returns might be 8%, but if they fall to say, 6%, you will end up with less than you planned, and might not have enough to pay off the mortage.

Also, while the market on average may have a return of 8%, this is only an average. Different financial institutions will have different results. Its not possible to predict in advance which will perform best. See Mis-selling below.


3. Interest Rate Changes

When interest rates go up, the amount of interest you pay goes up. And vice versa when rates go down. If you have an endowment mortgage the change will apply to th
e whole amount of the mortage (because the loan stays the same throughout the life of the mortgage). If you have a repayment mortgage, the value of the loan has been falling as you make payments. Therefore, the later in your mortage you are, the smaller the effect of the rate change.

But now for the crucial part:

Interest rates and investment returns are broadly linked. If interest rates are falling, the returns on the endowment policy will fall. So if interest rates fall by 1%, the endowment returns could fall by 1%, and therefore the value of the policy at the end of the mortgage will be lower.

As a result, if rates are falling, you should put some of the saving you make from lower interest payments into higher payments on the endowment policy.

This is what has caught so many people out in the last few years. Interest rates used to be around 10%. Now they are around 6%. This makes mortgages more affordable in terms of interest payments, BUT IT MEANS THAT YOU HAVE TO PAY MORE FOR YOUR ENDOWMENT POLICY IN ORDER TO ENABLE YOU TO PAY OFF THE LOAN AT THE END.

If interest rates rise, you could end up with more in your endowment fund than you need. Which is nice! But, you cannot reduce the payments into the policy as a result. You will only get your hands on the extra at the end of the mortgage.


4. Mis-selling

It is certainly true that financial institutions are a touch economical with the truth. They will sell the benefits of endowments (eg cheaper than repayment mortgages), but will forget to stress that the returns are not guaranteed. They will also neglect to mention that falling interest rates can jeopardise the final value of your endowment policy.

The law sets outs standard for projecting the value to endowment policies when selling them. Standard rates of returns must be used in illustration. But these are only illustrations.

The Financial Institutions will also
show you past performance figures to show how good they are. Not surprisingly they choose a timescale that shows them in the best light. If ABC Investments Ltd has achieved a return of 15% a year for the last 3 years, but only 5% a year over the last 10 years, guess which they will show you. Whatever the past performance, it does not mean that this will continue into the future.

A further complication - the financial adviser, or mortgage adviser, might only be able to offer you a limited range of products (a tied adviser), or may offer you the whole range of products available (an independent financial adviser, or IFA). IFAs have a legal obligation to consider all products available and recommend the best for your circumstances. Tied advisers DO NOT.


5. Life Insurance

Endowment policies typically include life insurance. This will pay off your mortgage if you die. Repayment mortgages do not include life insurance, but you will need to take some out anyway. Therefore, when comparing costs, make sure that you are comparing like with like. If the endowment policy included life insurance, you need to add the cost of such insurance to the cost of the repayment mortgage.


6. Charges

Investments have costs. There is the dealing cost of buying and selling shares, and there are fees for the investment managers.

The bulk of the fees are usually charged in the first few years, so the amount being invested is less in these years.

Illustrations of endowment policies include these fees, so you down really need to worry about them.

Are they a rip-off? Yes and no. Someone does need to manage the investments, and transaction charges for trading in shares are real.

The catch with endowments is that the charges CAN be quite high, and within those charges there might be commission for the person trying to sell it to you. If the financial adviser at the bank will get more commission f
or selling you an endowment mortgage than a repayment mortgage then he/she MIGHT be tempted to mislead you.


7. Redemptions

If you end an endowment policy early, you will usually be stung badly with charges (not least because the fees are often wieghted towards to early years). Endowments are long term investments and only work in the long term. If you move house it is usually far better to continue with the existing endowment than to cancel it and set up a new one. If you are increasing the mortgage when you move, take out another endowment for the EXTRA amount.




So, where does this leave us?

Repayment mortgages pay off the loan over the specified life of the mortgage. If interest rates vary, the monthly payments vary, but the loan will still get paid off.

Endowment mortgages AIM to pay of the loan at the end of the mortgage. But it is not guaranteed. You could end up with a nice lump sum left over after paying off the loan. Or you might end up with a shortfall.

Repayment mortgages are certain. Endowment mortgages are uncertain, but potentially cheaper.


When taking out a mortgage, and making the choice between repayment or endowment, pay heed to the following:

1. Understand the differences between repayment and endowment at the outset.

2. Understand you own attitude to risk. If you want complete certainly that your mortgage leaves you with nothing owing at the end, then your decision is made for you. Repayment mortgages = certainty.

3. Find out whether your adviser is tied or independent.

4. Find out how much commission the adviser will receive for selling you different types of mortgage. If you think the commission is excessive, dont deal with them. Its your money that pays the commission!

5. Ask for everything in writing. Advisers may say all kinds of positive things, and will make hints that you may interpret as
statements. Ask for details in writing and then read them carefully. Its only the written statements that you can rely on.

6. Past performance is no guarantee of future returns.

7. Remember that if interest rates fall, you might need to pay more into the endowment policy in order to have enough at the end of the mortgage to pay off the loan. To be safe, use the saving in interest to pay more into the endowment. Find out if there is a facility to increase payments.

8. If interest rates rise you might end up with a windfall, but only at the end of the mortgage. You cannot reduce your payments to take advantage of this.

9. You cant really pay too much into an endowment policy. Any "overpayment" will simply result in a larger fund at the end, and could result in a nice windfall. Of course, the windfall is locked-up until the end of the mortgage.

10. Keep all paperwork in a file. If at a later date you think you have been mis-led, review what you have. If you arent sure go back to the people who sold you the mortage - they do have a duty to explain themselves.


Finally, you do not necessarily have to choose between one or the other. There is nothing wrong with having 50% of your mortgage as repayment, and 50% as endowment.


I hope this op has been useful. Buying a home and taking out the related mortgage are the biggest financial transactions most of us will ever enter into.

Eyes open, brain engaged.

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