Unit 5 Section 1
Mortgage Payment Methods & Products (20%)
• There are actually only 2 mortgage repayment methods available – CAPITAL REPAYMENT and INTEREST ONLY.
Capital Repayment Mortgage
• Also called Capital & Interest mortgage or a repayment mortgage
• Each monthly payment involves an element of interest and an element of capital • Therefore, it is a reducing loan with the balance outstanding decreasing all the
time
• In the early years, by far the biggest element of the payment is interest with this imbalance being reversed over time
• So the capital decreases slowly at first but towards the end of the term the decrease is much quicker
• If all the monthly payments are made the loan will be repaid in full at the end of the term
Advantages
• Easy to understand
• Easy to borrow more as the loan is reducing while the house value is probably rising
• Good method if you have a low risk profile
• Quite flexible in that the term can be extended if the borrower suffers hardship
Disadvantages
• This method does not automatically include life insurance which must be taken separately – known as decreasing term assurance.
The capital repayment mortgage
Decreasing term assurance
Interest Only Mortgages with a Repayment Vehicle
• The borrower pays only the interest due each month, no capital is repaid at all during the term
• The repayment of the capital is achieved at the end of the term through a capital repayment vehicle such as an endowment (see later)
• This method not very popular these days due to poor performance particularly by endowment policies
Advantages
• For endowment options only life insurance is included in the plan • Monthly payments are lower
• Some products such as ISAs, Personal Pensions have tax advantages Disadvantages
• With most of these there is no guarantee that the mortgage debt will be cleared at the end of the term – dependent on stock market performance
• Not a good method for the risk averse
• The loan amount does not reduce during the term Calculating Monthly Payments
Example
Bob takes out a 20 year capital and interest mortgage for £60,000 on an interest rate of 5% , and the monthly repayments are £354.78.
Assume the interest rate stays the same for the first 12 months at 5.0%. How much capital will he repay in the first year?
Step 1 – Work out the total annual payment (capital and interest
£ 354.78 x 12 mths = £4,257.36
Step 2 – Work out how much the annual interest payment is:
This is simply: Loan amount x interest rate £60,000 x 5.0% = £ 3,000
Step 3 – Deduct interest payment from the capital and interest payment
Capital Repayment Vehicles to pay off an Interest Only Mortgage
• The completion of the table below may help your revision of this area. The key capital repayment vehicles are:
Full (With Profits) Endowment Low Cost (With Profits) Endowment Unit linked Endowment
Unitised (With Profits) Endowment Individual Savings Account (ISA) Personal Pension Plan (PPP)
Once you have studied this section see if you can complete the table yourselves.
Method Capital Repayment Vehicle (CRV) Guaranteed Repaid on Death Guaranteed Repaid on Maturity Life Ins. Required Flex Term Risk Capital& Interest
N/A No Yes Yes-DTA Yes Low
Pure Int Only no CRV N/A Interest Only Full W/P Endowment Interest Only Low Cost W/P Endowment Interest Only Unit Linked Endowment Interest Only Unitised W/P Endowment Interest Only ISA Interest Only Personal Pension Plan Note
As mortgage advisers we are not able to sell any of these products as they are investment based. You would need to be a qualified financial adviser.
Endowment Policies – A quick guide
• An endowment policy is in essence a ‘savings plan’ that you make regular monthly payments into each month in addition to your monthly payments on an interest only mortgage
• The idea is that by the end of the mortgage term, this ‘savings plan’ will be at the very least equal to the mortgage balance – on maturity eg when the policy ends • In addition, all endowments have built in life insurance so that if the policy holder
dies during the term, the full mortgage balance will be paid off – death benefit • Personal pension plans, ISAs and other repayment vehicles do not provide built in
life cover which would need to be purchased separately, usually as level term cover.
Full With Profits Endowment Policies
• This policy guarantees to pay off the mortgage debt on the earlier of Death during the term of the policy
On maturity as long as the sum assured is equal to the mortgage
• No risks with these but because they are guaranteeing so much they are extremely expensive
Low Cost With Profits Endowment Policies
• Designed to be a cheaper alternative to the Full Endowment
• This option does not guarantee to pay off the mortgage in full on maturity but will do so on death during the term.
• The main features of the Low Cost Endowment (LCE) are:
The policy starts with a guaranteed sum assured of around half of the mortgage balance
It is hoped that through the addition of bonuses, by the end of the term the fund will be large enough to fully clear the mortgage
As the fund is in theory always growing the amount needed to clear the mortgage on death is reducing, so in effect the life policy works on a decreasing term basis.
Bonuses
There are two types of bonus that can be added.
Reversionary (Annual)
• Not guaranteed to get these but once added it can’t be taken away • Added to the plan annually if given
Terminal
• Not guaranteed to be given this bonus either • Paid on death or maturity
• On a low cost endowment the granting and size of the terminal bonus will determine whether there will be enough to pay off the mortgage
Low Start Low Cost With Profits Endowment Policies
• These operate in exactly the same way as a normal low cost endowment • Premiums are lower to begin with perhaps half the level of a normal low cost • Premiums will increase by around 20% each year for the fist 5 years compound
which ends up more than doubling the initial premium
• Although it is cheaper to begin with, the overall cost is higher
• This sort of plan could suit a soon to be qualified professional – accountant
Advantages of the low cost with profits endowment
• the guaranteed sum assured will be paid on maturity providing premiums are paid. • The premiums are much lower than on a full endowment
• The mortgage will be paid off on death • There is a possibility of a surplus
• The policy combines investment and life cover. Disadvantages of low cost with profits endowment
• The final value on maturity is not guaranteed to pay off your mortgage • All “With Profits” policies are inflexible which means that the term and the
premium cannot usually be either extended or increased. There are also heavy penalties on early surrender.
Unit Linked Endowment Policies
• Different to all the With Profits plans
• Carry a greater risk but also a greater reward – chance of a surplus
• Premiums are used to purchase a broad range of units on the stock market • Some units are cancelled each month to pay for life cover which is built in as are
all endowments – guaranteed death benefit
• No guarantee at all of what the fund will be on maturity as it will depend on how all these units will have performed on the stock market
• The units have two prices:
Offer Price – you buy the units at the offer price
Bid Price – you sell the units back to the Fund Manager at the bid price • Charges
o the difference between the bid and the offer price – bid/offer spread o policy fee charge – a fixed monthly deduction
o annual charge – around 0.5-1.5% of the fund value o early surrender charge on surrender in the first 10 years
• Most providers offer periodic reviews to see if the plan is on target usually after 10, 15, 20 years and then every year thereafter
Key Issues
• Unit linked plans have a flexible maturity date so the policyholder can repay the mortgage early if he chooses or extend the term if necessary
• Very important note – all With Profits plans have a fixed maturity date which cannot be reduced or extended. Unit linked is the only endowment that is not a ‘With Profits’ plan.
• Unit linked is also flexible in that you can increase your premiums if you need to. • There is no final value guaranteed on maturity and charges can be high
Unitised with profit endowment
• This combines the security of the with profits endowment being able to benefit from bonuses and also the security of a minimum guaranteed sum assured on maturity.
• However, it is unitised in that you are allowed to switch into and out of other unit linked funds which have the potential for high rewards. However, these switches may incur a market value adjuster(MVA), which is a penalty incurred on
‘switching’.
• MVAs are also incurred on encashment before maturity.
Endowment Shortfalls and Complaints
• Low Cost endowment performance has been very poor in recent years due mainly to low interest rates and poor stock market performance
• Endowment providers have been ordered by the FSA to review all endowments that are being used for mortgage repayment
• Each plan must be reviewed at no less than two yearly intervals showing projected growth rates of the policy at 4%, 6% and 8%
• Where the review shows that a growth rate of 6% would be necessary to hit the target required, the provider must notify the policyholder to inform that some action is required
• The endowment provider must issue letters graded as red – high risk of a shortfall, amber – significant risk and green – no guarantee but it is currently on target. • The FSA has a fact sheet that recommends action be taken whenever a shortfall
seems likely
Unit Trusts, Open Ended Investment Companies and Investment Trusts • It is rare but both of these can be used to repay a mortgage
• They are both collective investments in which large numbers of investors contribute to create a fund
• You are playing the stock market in a similar way to Unit Linked Endowments • Charges are generally lower on these than on Unit Linked Endowments • No life cover is included – this needs to be arranged separately
Individual Savings Accounts (ISAs)
• This is the government’s tax efficient savings schemes • Contributions are limited in each tax year as follows
ISA
CONTRIBUTION LIMIT CASH MAXIMUM IN A
TAX YEAR £3,600 EQUITIES (STOCKS &
SHARES) MAXIMUM IN A TAX YEAR
£7,200 TOTAL
MAXIMUM CANNOT EXCEED £7,200
• If you save in an ISA you are entitled to keep all that you earn and not pay any tax on it.
• The maximum you can save in cash in a tax year is £3,600
• You can pay into your ISA whenever you want and you can stop making payments at any time.
• They can only be established in a single name- joint ISAs are not possible. • Since April 2004 the 10% tax credit on dividend income cannot be reclaimed by
the fund manager so the stocks and shares ISA or Equity ISA cannot be regarded as tax free but it is still extremely tax efficient.
Advantages
• No liability to income tax or capital gains tax • Flexible product
Disadvantages
• No guarantee that there will be enough to pay off the mortgage • Level term life assurance would need to be arranged separately
Personal Pension Plans (PPPs)
• A PPP or a stakeholder pension(SHP) can be arranged for anyone under the age of 75 including children
• Since April 2006 the maximum annual contribution is the higher of Up to 100% of their UK earnings
OR £3600
• There is however an overall maximum annual allowance which is currently £235,000. If this amount is exceeded there will be a tax charge on the excess. If your total pension fund is greater than £1.65 million there is a tax charge on the excess.
• Whether the individual has retired or not benefits can be taken at any time after 50 although this will rise to 55 from 2010
• Up to 25% of the fund can be taken as tax free cash
• The balance of the fund must then be used to buy a Compulsory Purchase Annuity or alternatively an income can be taken as draw down.
• The 25% tax free cash would normally be used to repay the mortgage. So, in order to repay the mortgage the total pension fund needs to be at least 4 times the mortgage balance.
• Contributions are paid net of basic rate tax @ 20%, so an actual contribution of £100 into your pension fund would cost you £80. Higher rate taxpayers would be able to reclaim a further 20% through self assessment, so it would cost them £60 • A PPP does not automatically include life assurance. Prior to December 2006, you
were able to get Pension Term Assurance. This was beneficial in that tax relief was available. This has now been withdrawn.
Mortgage Accounting Methods
Different lenders use different accounting methods that result in different total cost figures.
Annual Rest
• The annual amount of interest is debited to the mortgage account at the beginning of the year
• Any capital repaid during the year will have no effect on the amount of interest paid that year as it has already been calculated and debited
• This system neither penalises late payments nor rewards early payment
• If the borrower wants to reduce the amount of interest to be charged the following year, capital needs to be paid in towards the end of the current year.
Monthly Rest
• Monthly interest is debited to the account monthly like a credit card
• Borrowers benefit monthly from any capital repayments made the previous month • Lenders make less profit than annual as long as some capital is being repaid Daily Rest
• Daily interest is debited at the start of each day
• Early repayment of capital causes an immediate reduction in balance and therefore interest
• However, delaying payment even by a day causes more interest to be charged • Of the three this is the least profitable to the lender
Annual Review Schemes
• To help budgeting some lenders allow the monthly payment to be fixed for a 12 month period
• Sounds like this is a 12 month fixed rate but there is a difference
• The account is reviewed at the end of 12 months and depending on whether interest rates fell or rose during those 12 months, the borrower will be either in advance or in arrears.
• The following year’s payments could therefore be higher or lower depending on what has happened to interest rates
Annual Percentage Rate (APR)
• Introduced by the Consumer Credit Act 1974
• As charges and fees are included the APR will be higher than the flat rate of interest
• It assumes the following:
The interest rate will remain unchanged All payments are made on time
The loan will run for the full term with no early capital repayments • The following costs are included:
Total interest payable
Arrangement and administration fees Valuation fees
Conveyancing fees related to the mortgage Higher lending charges
Building & other insurance premiums attached to the mortgage Sealing fee for sealing the mortgage deed on redemption • The following are excluded:
Redemption interest eg – early repayment penalties Life assurance premiums
Default charges Tax relief is excluded
• Where the flat interest rate is quoted on an advertisement, the APR must also be shown more prominently.
UNIT 5- SECTION 1 – TEST
Question Answer Mark Comments / Notes 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
Unit 5 - Section 1 - Test
1 Which one of the following statements regarding interest payments on a repayment mortgage is TRUE?
a The first year’s payments will be made up of mainly interest and then
progressively become a greater proportion of capital
b The first year’s payments will be made up of mainly capital and then
progressively become a greater proportion of interest
c The capital and interest elements remain constant throughout the term
d All of the payment is interest on a repayment mortgage
2 A possible drawback of a capital and interest mortgage is that it:
a cannot be topped up
b is always more expensive than other methods
c may not fully repay loan
d requires additional life assurance
3 Which of the following guarantees to repay the loan at maturity?
a PEP / ISA b Personal Pension
c Full Endowment d Low Cost Endowment
4 In the case of arrears, which one of the following schemes allows for the term of the mortgage to be extended?
a With-profits endowment mortgage
b Low cost endowment mortgage
c Low start endowment mortgage
d Repayment mortgage
5 Fred’s premium on his low cost endowment increased by £20 in March 2006 because:
a he chose a low start plan b bonus levels reduced
c his health deteriorated d of the withdrawal of MIRAS
6 The MINIMUM guaranteed maturity value of a unit-linked endowment policy is:
a the basic sum assured b the total of premiums paid
7 A higher rate taxpayer can receive tax relief on his pension mortgage contributions at:
a 10% b 20% c 22% d 40%
8 Some borrowers like to feel that the amount they owe to the lender is being reduced by their monthly mortgage payments. They should choose a:
a fixed rate mortgage b endowment mortgage
c repayment mortgage d ISA mortgage
9 A low cost endowment is usually a combination of which of the following types of assurance?
a With-profit endowment and level term assurance
b Without-profit endowment and level term assurance
c With-profit endowment and decreasing term assurance
d With-profit endowment and increasing term assurance
10 Which one of the following is FALSE with regard to ISA mortgages?
a Separate life assurance may be necessary
b Only UK residents (for tax purposes) are eligible
c All income and growth is tax free in the hands of the investor
d The maximum regular payment is £800 per month
11 The MAXIMUM tax-free cash sum that can be taken from a personal pension fund of £300,000 to repay an interest only mortgage is:
a £60,000 b £75,000 c £100,000 d £150,000
12 Alison paid £1500 into a cash ISA in May of the current tax year and now wishes to arrange an ISA mortgage. How much can she contribute to an equity ISA this year?
A £4000 b £5700 c £5,500 d £7200
13 Which interest accounting methodology fails to penalise late payers of their monthly payments?
a Annual review system b Annual rest system
14 Jason would like to arrange a pension mortgage and has yet to start any pension arrangements. Based on his income of £28,000, what is the maximum he could pay into a personal pension this tax year and gain full tax relief?
a £3,600 b £28,000 c £215,000 d £1,500,000
15 Alison is looking for an interest payment method that will benefit her if she makes some of her payments early. She should choose:
a fixed payments
b annual rest
c daily interest
d annual review
16 John has a 20-year repayment mortgage for £75,000 on an annual rest basis. If the interest rate is fixed at 6% for the first 12 months and the monthly repayments are £7.30 per £1,000 borrowed, how much capital will he repay in the first year?
a £1,090 b £1,640 c £1,900 d £2,070
17 Tom and Mary have an interest-only mortgage with a low-cost with-profits endowment policy as the repayment vehicle. Which of the following statements in respect of the policy is correct?
a Annual reversionary bonuses and a final terminal bonus may be added to the
basic sum assured, but these are not guaranteed
b Annual reversionary bonuses and a terminal bonus may be added to the
guaranteed death benefit, but these are not guaranteed
c Annual reversionary bonuses will be added to the basic sum assured, and these
are guaranteed
d Annual reversionary bonuses may be added to the guaranteed death benefit, but
these are not guaranteed
18 Colin is paying £30 per month to the cash element of an ISA in this tax year. He is considering an ISA linked interest-only mortgage. What is the maximum additional amount he can save in the stocks and shares element of his ISA this year?
19 What are the rates of growth permitted by the FSA for illustrations of the projected benefits from a unit-linked endowment when used to repay an interest only
mortgage? a 4%, 6% and 8% b 5%, 6% and 7% c 5%, 7% and 9% d 6%, 7% and 8%
20 The amount available to repay an interest only mortgage from a unit-linked investment depends on the price of the units on the repayment date. The price at which the units are cashed in is known as the:
a bid price
b cash price
c offer price
d reserve price
21 Which of the following statements about a personal pension plan is correct?
a At retirement the pension provides an income that is free of income tax under
current legislation
b A maximum of 20% of the fund value can be taken as a tax-free lump sum on
retirement
c Full tax relief can be claimed on contributions to the plan
d The lump sum and pension benefit can be taken at any time provided
contributions have been made for at least ten years
22 Which of the following statements in respect of a 20-year repayment mortgage is correct?
a The capital element will not reduce during the first 5 years of the mortgage term
b Monthly payments decrease as the capital element decreases over the term
c The interest element of the monthly payment gradually reduces throughout the
term
d The interest element of the monthly payment remains constant throughout the
term
23 Which of the following would provide a borrower with a high degree of certainty that the loan will be repaid in full by the end of the mortgage term, together with a cheap form of life assurance?
a A full with-profits endowment policy
b A low-start low-cost endowment policy
c An interest-only mortgage with level term assurance
24 Which of the following is a benefit of using a unit-linked endowment policy in conjunction with an interest-only mortgage?
a It is ideally suited to the low risk customer
b The units can be cashed in at any time making it possible to repay the mortgage
early
c Reversionary bonuses are normally credited to the policy each year
d This type of policy will always have a fixed maturity date
25 Which of the following is EXCLUDED by a lender when calculating the annual percentage rate (APR)?
a Mortgage indemnity guarantee premiums
b Mortgage valuation fees
c Arrangement fees