Mortgage payment methods and products

Section 1

Mortgage repayment methods

Although there are many mortgage products currently available, there are only two mortgage repayment methods, ie capital repayment (or capital and interest) and interest-only. It is, therefore, important not to confuse mortgage products, such as fixed rate and discounted, with repayment methods.

Until the mid 1970s this was the conventional method of repaying a mortgage. Interest-only loans then became almost the norm, but in the past two or three years the capital repayment method has again become more popular.

Under this method, each monthly payment consists of a capital element and an interest element. If the borrower makes all monthly payments when they fall due and adjusts them in line with changes in the interest rate charged, the loan is guaranteed to be fully repaid at the end of the mortgage term.

At the beginning of the mortgage term the monthly payment consists largely of interest. The amount of capital owed gradually reduces as the term progresses. In other words, the interest part of each monthly payment decreases, while the capital element increases.

However, it does take several years before there is any noticeable reduction in the amount of capital owed, and this can cause concern to some borrowers who may feel that their loan will never be repaid.

The monthly payment on a new capital repayment loan of £60,000 over 25 years at an interest rate of 5.0% is £354.78. This is taken from computerised repayment tables.

Assuming that the interest rate remains unchanged for the whole of the first year, the amount of interest payable in that year is:

60,000 x 5 = £3,000.00

100

The interest element of each monthly payment in the first year is

3,000 = £250.00

12

The amount of capital repaid in the first year is therefore

(£354.78 – £250.00) x 12 = £1,257.36.

If the interest rate was 10.0%, the monthly payment on £60,000 over 25 years would be £550.86.

The interest element of each monthly payment in the first year is

60,000 x 10 = £500.00

100 x 12

The amount of capital repaid in the first year is therefore

(£550.86 – £500.00) x 12 = £610.32.

These calculations illustrate that the higher the interest rate charged, the smaller the amount of capital that is repaid during the early part of the mortgage term.

The capital repayment method has in-built flexibility. For example, the borrower may be permitted to maintain his existing monthly payment when the interest rate is increased. This will have the effect of extending the mortgage term, although probably only marginally, but may help him through a short period of financial difficulty. Similarly, the borrower may decide to maintain his existing monthly payment if the interest rate is reduced. This will shorten the mortgage term, although again perhaps for a temporary period only.

A borrower who has £52,000 outstanding on his capital repayment mortgage is paying £373.36 per month. The current interest rate is 5.5% and there are 19 years remaining on the mortgage term.

If the interest rate is increased by 0.5% to 6.0%, his monthly payment will increase by £15.03 to £388.39.

If he chooses to maintain his existing payment, the mortgage term will be increased by just less than two years. The lender may be quite happy to accept this situation. It might be only a temporary increase in the mortgage term as the interest rate could fall back to 5.5% within a few months. However, if the interest rate should be increased again, then it may not be possible for the existing monthly payment to continue to be maintained if the lender considers that the mortgage term would be unduly extended.

As far as the borrower is concerned, the main advantages of the capital repayment method are:

The main disadvantage is that there is no built-in life cover. This must be arranged separately, although decreasing term assurance cover is generally inexpensive.

The main disadvantage is that there is no built-in life cover. This must be arranged separately, although decreasing term assurance cover is generally inexpensive.

With an interest-only mortgage, the borrower makes monthly mortgage payments consisting of interest only. The full capital amount remains outstanding during the mortgage term and is repaid in one lump sum at the end of the term. This means that the mortgage payments each month will be lower than those of a repayment mortgage for a similar amount. The borrower usually arranges an investment vehicle to build up the capital needed to repay the mortgage at the end of the term. The investment runs alongside the mortgage but is separate from it; the cost should be taken into account when calculating the overall costs of the mortgage arrangement.

In most cases no guarantee is given that the investment will be sufficient to repay the debt in full. The most common repayment vehicles are low-cost with-profit and unit-linked endowment policies.

Many endowment policies taken out in the past appear increasingly unlikely to produce enough to fully repay the associated mortgage. For this reason interest-only loans have become increasingly unpopular with borrowers, although some lenders allow interest-only loans to be taken out without any supporting repayment vehicle in place.

This effectively puts the responsibility on the borrower to ensure that he has the means to fully repay the loan at the end of the mortgage term. He may, of course, arrange some form of investment product or simply rely on accumulated savings.

Some people are quite happy to borrow on this basis, particularly as the monthly mortgage payment on an interest-only basis is considerably less than that using the capital repayment method.

Consider a loan of £70,000 at an interest rate of 6.0% over a 25-year term.

On an interest-only basis, the monthly payment would be £350.00, whereas using the capital repayment method it would be £456.33.

The saving of over £100 per month would be particularly useful to a first-time purchaser who has borrowed the maximum his income will allow, but who expects to earn considerably more within the next two or three years when some form of professional training is completed. At that stage it could well be possible to switch to a capital repayment mortgage, thus removing the need to worry about how the capital would be repaid at the end of the mortgage term.

Mortgage repayment vehicles include:

While information on these investment-backed products can be given by mortgage advisers, only those who are authorised under the Financial Services and Markets Act 2000 can give advice and make a recommendation.

An endowment policy, whether with-profit or unit-linked, serves two purposes, ie:

In other words, an endowment policy provides both protection and investment elements for the borrower.

Personal pension plans and ISAs, on the other hand, provide investment but do not include built-in life cover. This has to be purchased separately, usually as level term assurance.

With-profits endowments offer policyholders a degree of guarantee with the potential for capital growth. Regardless of the type of with-profits endowment, the basic structure is:

• Through reversionary bonuses. Reversionary (annual) bonuses are usually added to the policy each year as a percentage of the plan’s GSA. Once added, the reversionary bonus is guaranteed to be paid on maturity, providing the plan remains in force and premiums are paid. For example, Anna has a plan with a GSA of £50,000, and the company declares a reversionary bonus of 2% on its with-profits policies. This means Anna would receive a bonus of £1,000. This would increase the GSA to £51,000. Reversionary bonuses can be calculated in a number of ways. They can be calculated on a ‘simple’ basis; this means that they will always represent a percentage of the original GSA. They can also be calculated on a compound basis; this means they will represent a percentage of the original GSA plus bonuses already added. Some companies declare a bonus based on the initial GSA, and a further sum based on accrued bonuses. Examples of the three methods are given at the end of the section.
• Through terminal bonuses. Terminal bonuses are usually added at maturity, or sometimes on earlier death. They can represent a large proportion of the final policy value, perhaps as much as 40%. They are designed to reward long-standing policyholders;

GSA £50,000, end of year 1 bonus declared 3%. Reversionary bonus added £1,500, GSA now £51,500. End of year 2, bonus declared 2% - reversionary bonus added £1,000, GSA now £52,500.

GSA £50,000, end of year 1 bonus declared 3%. Reversionary bonus added £1,500, GSA now £51,500. End of year 2, bonus declared 2% - reversionary bonus added £1,030 (£51,500 x 2%), GSA now £52,530.

GSA £50,000, end of year 1 bonus declared 3%. Reversionary bonus added £1,500, GSA now £51,500. End of year 2, bonus declared 2% on GSA and 1.5% on accrued bonuses. Bonus – on GSA £1,000, on accrued bonuses £22.50.

The full endowment is the original interest-only product, introduced over 40 years ago.

The full endowment is a with-profits plan with a guaranteed sum assured (GSA) equal to the mortgage amount. This means that the mortgage is guaranteed to be paid off by the GSA, with added bonuses providing a cash surplus.

All this comes at a cost, however. The premium will be calculated based on the need to pay the guaranteed sum assured at the end of the term. This makes the full endowment much more expensive than the low cost versions. Although there is the guarantee that mortgage will be paid off, and the probability of a surplus at the end, the overall cost is unlikely to make it a practical choice. For those wanting guarantees, a repayment mortgage would be a better and more cost-effective choice.

If the full endowment is cashed in before the end of the term, the surrender value may not represent the fair value of the plan at that point.

If a with-profit policyholder wishes to discontinue his policy, but not actually surrender it, then he can make it ‘paid up’. This means that no further premiums are paid and the policy has a reduced guaranteed sum assured and death benefit. Reversionary bonuses added to date are unaffected and remain attached to the policy. The value of the policy will continue to grow, although at a much lower rate, as no further premiums will be paid.

The low-cost with-profit policy was developed in the 1970s as a more affordable alternative to the full with-profit policy. Over the next two decades they became a very popular mortgage repayment vehicle. The low cost with-profits policy operates on a similar principle to the full endowment, but with some significant differences.

• The guaranteed sum assured (GSA) is typically 30 to 40% of the mortgage amount. As with the full endowment, the GSA is payable on the earlier of maturity or death during the term. This is significant, in that the plan does not guarantee to repay the mortgage at the end of the term.
• The premium is worked out by assuming that the guaranteed sum insured plus a percentage of the anticipated reversionary bonuses (typically 80%) will provide sufficient capital on maturity to repay the loan. If these assumptions prove to be wrong, and the terminal bonus is not sufficient to plug the gap, the maturity proceeds will not repay the loan: the final sum is not guaranteed.
• In the event of death during the term the guaranteed sum assured plus accumulated reversionary bonuses will be paid. A form of decreasing term assurance (DTA) is built in to plug the gap between the value of the guaranteed sum insured plus accrued bonuses and the mortgage. This ensures that the mortgage can be repaid on death before the end of the term.
• A low-cost, low start endowment works on similar lines, but the premiums in the first five years are lower. The premiums increase by 20% in each of the first five years, leading to a doubling of the premium by that stage. From then onwards the policyholder is paying a higher premium than would be the case with a low cost endowment.

• The guaranteed sum assured will be paid on death during the term, meaning the mortgage can be paid off.
• Providing the policy remains in force to maturity, any gains made are locked in and cannot be lost.
• There is the possibility of a surplus over the mortgage amount.
• The policy combines investment and life cover.

Unit-linked policies were introduced as an alternative to with-profit policies. Although they carry a greater risk they also provide the possibility of much higher returns than with-profit policies.

The unit-linked endowment is designed to accumulate capital by the end of a set term. It differs from the with-profits endowment in the way the fund is built up.

Premiums buy units in one or more of a range of unit linked funds. Not all the premium is invested as some is taken to cover expenses. The value of units is directly related to the performance of the fund, so there is no smoothing effect, as growth (or losses) is directly reflected in unit prices. The value of the plan is simply the number of units held in the plan multiplied by the current fund price. There are no bonuses.

The premium is calculated so that, if investment funds grow at a specified annual rate, typically 7.5%, the maturity proceeds should be sufficient to repay the loan.

The only guarantee offered is that the loan will be repaid in the event of death during the term; the maturity value depends entirely on fund performance. Unit prices can, and do, fluctuate. The guaranteed death benefit is provided through a combination of the plan’s value and decreasing term assurance. For example, assume a plan has been in force for 10 years, has a death benefit of £75,000 and a current unit value of £25,000. If the policyholder died, the death benefit would comprise a return of the fund (£25,000) plus a DTA payment of £50,000, giving a benefit of £75,000. Units are deducted from the fund each month to pay for the cost of the life cover, which will always be the difference between the sum assured and the fund value.

Units have two prices – an offer price at which units are purchased by the client and a bid price at which units are bought back by the fund – the bid price is lower than the offer price.

The plan will be taken out with a set term and a premium calculated to achieve the target maturity amount. However, the plans are flexible, and it may be possible to increase or decrease the premiums, or extend the term, subject to the policy rules and qualifying rules.

Mortgage related unit linked endowments are subject to policy reviews, where the insurer checks the plan’s progress in relation to the maturity target. Where the plan is not on track, the insurer is likely to recommend an increase in premiums. On a typical 25-year policy, reviews would take place after 10, 15 and 20 years, becoming annual after that.

When a policy is taken out the investor can choose how much of each premium is invested in each of the available individual funds.

The range of funds offered will include high, medium and low risk investments, and the policyholder can base his selection on his overall attitude to risk. This represents an advantage over a with-profit policy where the policyholder has no say over how premiums are invested – they are invested in the company’s with-profit fund.

The range of funds include:

• cash – these funds are available on the money markets and through building societies. They represent a very low risk and provide virtually a 100 % guarantee that all money invested will be returned. However, they earn relatively low rates of interest and are seldom used for mortgage purposes, although they can be useful in the last few years of a policy when growth has been good and the investor wants to consolidate gains made;
• fixed interest – these are mainly gilt-edged government securities. Again, these are relatively low risk but do not offer significant growth and are rarely used for mortgage purposes;
• managed (or balanced) fund – this is the choice of most mortgage investors. The fund mandate is to produce reasonable capital growth without taking excessive risks. The manager will hold most of the assets in blue chip equities and gilts, adjusting the balance and selection as appropriate.
• UK equities – these are investments in the shares of blue-chip companies that trade on the London Stock Exchange. They represent a medium risk in the short term, but in the medium to long term they can be expected to produce a reasonable level of dividend income as well as capital growth;
• specialist equities – these are investments in the shares of companies that operate in a specific sector such as technology or pharmaceuticals. They represent a medium to high risk;
• property – these are investments in commercial property. They can be volatile in the short term but can normally be relied upon to provide healthy returns in the medium to long term;
• international – these are investments in the shares of companies throughout the world. They carry a much greater risk than UK equities.

These policies combine the security of a with-profit policy with the greater growth potential of a unit-linked policy.

The investor buys units in a with-profits fund. As bonuses are declared, the value of each unit will increase proportionately and cannot be reduced in future. Most unitised with-profits policies allow the investor to switch into and out of other unit linked funds. Switches out of the unitised with-profits fund might incur a ‘market value adjuster’ (MVA), whereby the company will reduce the value of units transferred to protect the interests of other investors. This is usually invoked in times of poor fund performance. MVAs are also used on encashment before maturity.

The performance of many low-cost with-profit and unit-linked plans has been very poor since the mid 1990s. The reasons for this are:

There has also been much concern over the standard of advice given by some financial advisers, with the risks associated with investment plans not being adequately explained to clients.

In 1999 the Financial Services Authority (FSA) instructed endowment providers to review the performance of all endowment plans that were being used as mortgage repayment vehicles. Each plan has to be reviewed at least every two years and the policyholder must be provided with an illustration of the maturity value based on annual growth rates of 4%, 6% and 8%.

Where the annual rate of growth required to fully repay the mortgage on maturity is 6% or less, then the policyholder is advised that no action is necessary. However, if an annual rate of growth of more than 6% is needed to reach the target amount, then the policyholder must be advised that some form of action needs to be taken.

The endowment provider’s letter to a policyholder is classified as being ‘red, amber or green’.

A ‘red’ letter indicates that there is a high risk that the policy will not pay the target amount at the end of the mortgage term. A strong recommendation to take some form of action is made.

An ‘amber’ letter indicates that there is a significant risk that the target amount will not be met and recommends that some action should be taken if the policyholder is concerned. If he is not too worried about the risk, then the advice given is to carefully check future projection letters.

A ‘green’ letter states that the policy is on track to meet the target amount but warns that there is no guarantee that it will stay on track in the future. Again, the advice is to carefully check subsequent projection letters.

The various courses of action that the policyholder can consider are detailed in a FSA Factsheet that accompanies the letter from the endowment provider. They are as follows.

• Switch the amount of the projected shortfall from interest-only to capital repayment. This guarantees that the projected shortfall figure will be repaid, but only if all future monthly payments are made on time. However, should another projected shortfall materialise, then it would be fairly easy to further increase the capital repayment part of the loan.
• Repay some, or all, of the mortgage early, either by means of a lump sum or by making additional payments each month. This is an easy option to manage, although the lender may impose a redemption penalty on overpayments. In this case it might be better to place the overpayment amounts into a savings account and then transfer the total to the mortgage account when the redemption penalty period has expired. If interest is calculated on an annual basis then it would certainly be more cost effective to accumulate savings and make a capital reduction shortly before the date on which annual interest is debited to the account.
• Convert the whole mortgage to a capital repayment basis. This will guarantee that the loan will be fully repaid by the end of the mortgage term if all future monthly payments are made on time. However, the monthly payment will increase considerably, particularly if the remaining term is 20 years or less.

• Accumulate savings and use these to reduce the mortgage debt. The savings could be put in an ordinary deposit account, cash ISA or equity ISA. However, this is probably best as a short-term measure, eg to cover a period during which a redemption penalty applies. As soon as the penalty period expires the savings can be used to reduce the debt.
• If an equity ISA were chosen, this should be regarded as more of a long-term investment, ie five years or more. The risk involved is much the same as for the endowment policy itself and the borrower would need to take this into consideration.
• Extend the term of the endowment policy and the mortgage. The permission of both the endowment provider and the lender will be required, and will only be possible on a unit linked policy. Extending the term of the policy may have taxation implications if it ceases to be classed as a qualifying policy and will still not guarantee that its maturity value will be sufficient to fully repay the loan.

• Increase the endowment premiums. It may be possible to increase premiums into the endowment in order to boost the maturity value. If this facility is available, charges may be levied for varying the policy and there may also be taxation implications. The additional premiums will still not guarantee that the policy will fully repay the loan at the end of the term.

The choice of option depends on the individual policyholder. The guidance issued by the FSA in its Factsheet gives a clear indication of the relative merits of each option and explains the risks involved.

The FSA Factsheet strongly recommends the policyholder to take action sooner rather than later if a shortfall looks likely. It also recommends that immediate action should be taken if it is felt that there are grounds for a valid complaint. These grounds are if:

• the adviser did not explain that an endowment policy would not necessarily mature with sufficient funds to fully repay the mortgage, and that the policyholder would not have accepted this risk if he had known about it;
• the maturity date of the endowment policy is after the agreed redemption date of the mortgage;
• the maturity date of the endowment policy is after the policyholder’s selected retirement date and the adviser did not specifically check that the premiums would be affordable after retirement;
• the adviser recommended that an existing endowment policy be surrendered and replaced with a new one.

Individual Savings Accounts (ISAs) were introduced on 6 April 1999. They replaced PEPs and TESSAs from that date, although existing PEP holdings are not affected.

For the purposes of mortgage repayment, equity ISAs replaced PEPs in a relatively seamless transition.

The characteristics of an ISA mortgage are:

• interest only is paid to the lender; the entire capital remains outstanding throughout the term;
• investment is made into an Individual Savings Account on a regular basis;
• separate life cover will usually be needed to repay the loan on early death;
• at the end of the mortgage term the ISA fund is used to repay the capital.

There are two types of ISA.

An Equity ISA can contain any or all of the following investments:

• shares;
• unit trusts;
• investment trusts;
• Open Ended Investment Companies;
• life assurance (previously a separate ISA category);
• Gilts;
• Corporate Bonds.

Cash ISAs are deposit accounts offered by banks, building societies and National Savings. They pay interest on capital invested, which may be variable or fixed, depending on the product. It is not common for cash ISAs to be used for mortgage repayment due to the low relative returns.

ISAs are further divided into Maxi and Mini ISAs.

A maxi ISA is one where all the investment is under the control of one manager (provider). The maximum investment is £7,000 a year, of which up to £3,000 can be held in cash. The manager must offer an equity option.

With a mini ISA, each ISA category can be held with a different manager. For example, the investor may hold a mini cash ISA with a building society and a mini equity ISA with a unit trust manager. The investment limits are £4,000 for equity mini ISAs and £3,000 for mini cash ISAs.

An investor cannot invest in a mini and a maxi ISA during the same tax year.

Individuals must be aged 18 or over (16 or over for cash ISAs), and resident and ordinarily resident in the UK for tax purposes. ISAs are available in single names only and it is not possible to take out an ISA for another person.

• The government has guaranteed that ISAs will be available for at least ten years, although there will be a review in 2006 to formulate any changes to be made at the end of the ten years.
• ISA income and capital growth will be free from income and capital gains tax, although managers are unable to reclaim tax credits on share dividends.
• ISAs can only be offered by approved ISA managers – life insurance and unit trust companies, stockbrokers, banks, building societies and so on.
• Withdrawals can be made from the account at any time without affecting the tax-free status of the ISA. There is no statutory lock in period, although ISA providers can impose their own minimum investment period if they wish.
• There is no limit on the total value of ISA holdings.

A personal pension plan can be arranged by, or for, almost any person under the age of 75 who is resident in the UK. The one exception is the employee earning over £30,000 a year who is a member of his employer’s occupational pension scheme. This means that personal pensions are available to children!

Reference in this section to personal pensions includes stakeholder pensions. In essence, stakeholder pensions are personal pensions, the only difference being rules relating to charges and policy terms imposed by the provider.

The main personal pension rules are as follows.

• The maximum annual contribution is the greater of £3,600 or a percentage of net relevant earnings. The percentage is determined by the individual’s age:

• Benefits can be taken at any time from the age of 50 to the 75th birthday. It is not necessary to retire in order to take the benefits. Those in certain special occupations can take the benefits earlier than 50. For example, professional footballers can take benefits from 35, and models from age 40.
• Up to 25% of the fund can be taken as a tax-free lump sum, with the balance used to provide an income for life. With a pension mortgage the tax-free cash is used to repay the mortgage. This means that the projected fund must be at least four times the mortgage amount.
• Tax-free cash and income must be taken at the same time. It is not possible to take the cash and delay the income.
• Contributions qualify for income tax relief at the individual’s highest marginal rate.
• Contributions are paid net of basic rate tax, regardless of the individual’s employment or tax status. This means a gross contribution of £100 will require an actual payment of £78. Employers can contribute to an employee’s personal pension but will pay gross contributions and claim the payment as a business expense.
• Higher rate tax payers can claim an additional 18% through self-assessment.
• Income received will be taxed as non-savings income through the PAYE system.
• Personal pensions belong to the individual and cannot be assigned to a lender; neither can they be arranged in joint names.

Until relatively recently it was usual for all lenders to calculate mortgage interest on an annual basis, the actual calculation date normally being 1 January.

This method is easy to operate and benefits the lender, as on a capital repayment mortgage interest is charged on the balance outstanding at the beginning of the year, and no adjustments are made for the capital that is paid off with each monthly repayment in the ensuing 12 months. Consequently, a borrower would be no better or worse off if he made only one substantial mortgage payment shortly before the year-end. In fact he could argue that he would actually benefit from such an arrangement because the money that would otherwise be used to make monthly payments could earn interest in a savings account. The lender, of course, would almost certainly not approve of such an arrangement.

Calculation of interest on a monthly basis has become more common in recent years, although it does not benefit the lender as less interest is received on a capital repayment mortgage.

The borrower, of course, does benefit. For example, the monthly payment made in March is made up partly of capital that reduces the outstanding debt. This reduced figure is used to calculate the interest to be charged for the following month, April. Over the whole mortgage term the borrower pays considerably less interest than would be the case on the annual calculation basis. Any overpayments that are not subject to an interest penalty will also almost immediately reduce the amount of interest charged to the account.

The daily calculation of interest has become quite common with the introduction of flexible mortgages into the UK. Once again, the lender receives less interest over the term of the mortgage, whereas the capital repayment borrower is even better off than under the monthly method of calculation. Any overpayments result in an immediate reduction in the amount of interest charged, thus encouraging borrowers to make additional payments whenever possible to considerably reduce the term of their mortgage.

Of course, whichever method of calculating interest is used will make no difference to the interest-only borrower unless additional payments are made to reduce the outstanding debt.

The purpose of an annual review scheme is to enable the borrower to fix his monthly payment for a 12-month period based on the interest rate being charged at the beginning of the period. This would be particularly beneficial to a borrower on a tight budget.

The account is either debited or credited with interest in line with any changes to the interest rate charged during the 12-month period.

The account is then reviewed at the end of the period to enable a new monthly payment to be set for the next 12-month period. This payment will be based on the capital outstanding and the interest rate applicable at the time. The balance will be more than at the beginning of the previous period if there had been an overall increase in the interest rate, resulting in more interest being charged to the account than was actually paid by the borrower.

Conversely, if there had been an overall reduction in the interest rate, then interest would have been overpaid during the year. This overpayment would have had the effect of reducing the capital debt.

Lenders would normally only allow borrowers with a capital repayment mortgage to participate in an annual review scheme. Interest-only borrowers must usually amend their monthly payments in line with interest rate changes.

The advantage of being able to fix the monthly repayment for 12 months is offset to some extent because either:

The APR concept was introduced in the Consumer Credit Act 1974. Its purpose is to enable a prospective borrower to compare the true cost of borrowing from different lenders.

The APR is not actually a rate of interest. It is regarded as a ‘rate of charge’ because it takes into account some, but not all, of the costs involved in setting up and administering a loan. It is therefore usually higher than the advertised ‘flat’ rate.

In calculating an APR, the following assumptions must always be made by the lender:

The true cost of borrowing is arrived at by calculating a ‘total charge for credit’ (or TCC). It is this figure that is then converted into the APR.

The following costs and charges are included in the TCC calculation:

The following costs and charges are excluded from the TCC calculation:

The usefulness of the APR has been increasingly questioned, particularly with the growth in the number of fixed rate mortgages in recent years.

An advertisement that gives the ‘flat’ rate of interest for a loan must also show the equivalent APR. It is also a requirement that the APR is shown more prominently than the ‘flat’ rate. A general advertisement that does not include a ‘flat’ interest rate does not need to show an APR.

Section 2

Mortgage products and schemes

The variety of mortgage products now on offer to the public is undoubtedly highly beneficial as it enables every prospective borrower to find at least one product that matches his needs. However, the wide choice available also serves to confuse many people, thus making it essential, in most cases, that good quality advice is sought.

The standard variable rate (SVR) mortgage has for years been the most common product available. In recent years it has been challenged by a variety of options and is now less popular. Even borrowers who have had this type of mortgage for many years with the same lender have often remortgaged to take advantage of the benefits offered by new products.

The variable rate mortgage does exactly what its title suggests. The interest rate varies with market rates in general. For example, an increase in the Bank of England Base Rate will usually lead to lenders increasing their own standard variable rate, which in turn means that borrowers with a variable rate mortgage will see their payments increase. If the rates decrease, so will the borrower’s payments.

However, the person who wants a straightforward mortgage that is easy to understand may well still opt for this product, whether on a capital repayment or interest-only basis. No protection is offered against steep interest rate increases and generally the monthly payment has to be amended in line with each change in the interest rate charged. Some borrowers in the mid 1970s went through a period of monthly rate changes when the economy hit a rocky patch.

The market for fixed rate mortgages is highly competitive. Very attractive fixed rates are usually on offer to tempt borrowers to re-mortgage from their existing lenders. How can lenders afford to offer these competitive fixed rate products? It would seem that there is little or no profit to be gained, although a substantial number of new mortgage applications may well be received, thus encouraging asset growth.

The answer is that the rate to be charged is linked to the rate paid by the lender on a tranche of funds raised on the wholesale money markets. If a lender raises £100m from the market at a fixed rate of 4.8% over a four-year period, then this amount may be made available to new borrowers in the form of a four-year fixed rate mortgage at 5.2%. Once the £100m has been lent, the product will be withdrawn and possibly replaced with a new product at an interest rate linked to the prevailing money market rates at that time.

The main benefits of a fixed rate mortgage to the borrower are obvious in that it helps him to budget. He will know exactly what his monthly payment will be for a given period of time, and will be protected against interest rate increases during that period. However, there are other matters that need to be considered, eg:

In considering whether to choose a fixed rate mortgage the applicant must also bear in mind the possibility that interest rates will rise during the fixed rate period, resulting in a substantial increase in monthly repayments when that period ends.

This type of mortgage simply offers a discount off the lender’s standard variable rate for a given period and is designed to attract new mortgage business in the same way as a fixed rate product.

Some discounted mortgage products offer what is known as a ‘stepped discount’. For example, the discount may be 1.0% in the first year, 1.25% in the second year and 1.5% in the third year. This is designed to give further encouragement to the borrower not to move his mortgage elsewhere before the discounted period ends.

As with the fixed rate mortgage, there are certain matters that need to be taken into consideration when a discounted rate mortgage is being contemplated. These are:

Although a discounted rate mortgage is a variable rate product, the borrower does have an assurance that for a given period he will be paying less than the lender’s standard variable rate. In choosing a suitable product, therefore, the individual needs to be aware of the different standard variable rates charged by lenders. Generally, lower rates are charged by building societies than by banks.

This is a variable rate mortgage that benefits the borrower in two ways:

• the borrower’s mortgage will follow the lender’s variable rate up to a certain level (the capped rate) for a specified period. The payable rate may include a small premium over the lender’s SVR – it could, for example be the SVR plus 0.25%;
• where the lender’s rate moves above the cap, the borrower will pay the capped rate. In other words, there is a limit (cap) on the rate the borrower will pay. This means advantage can be taken of all reductions in the lender’s standard variable rate whilst at the same time the borrower knows the maximum he will pay;
• there is likely to be an arrangement fee payable;
• there will probably be an early repayment charge on redemption during the capped period (and sometimes for a period afterwards);
• there may be a requirement for the compulsory purchase of an associated insurance product.

Although not common at the moment due to low interest rates, some capped mortgages come with a ‘collar’. This represents the minimum interest rate payable during the term. In this way the lender sets an upper and lower limit to the interest payable. For example, a mortgage with a 7% cap and a 3% collar would allow the rate to vary within those limits, but if rates went above 7% the borrower would pay 7% and if they went below 3% he would pay 3%.

A capped mortgage will be worth consideration by somebody who feels that interest rates are about to rise, but still wants the security of knowing the maximum payment, although the differential between the lender’s standard variable rate and the capped rate will be an important consideration.

This is also a variable rate mortgage. The rate charged follows the Bank of England Base Rate (BOEBR) for a given period that may be up to ten years.

The rate charged may be a fixed percentage above the BOEBR for the entire period or may actually be a fixed discount off the BOEBR for a given period,followed by a fixed percentage above for the remaining term. For example, the interest rate charged on a five-year Base Rate tracker mortgage might be BOEBR – 0.25% for the first year, then BOEBR + 0.5% for the remaining four years.

The main advantages of a Base Rate tracker mortgage are:

There may be occasions when a lender will make a small reduction in its standard variable rate even though the BOEBR has not been reduced. In these circumstances borrowers with a Base Rate tracker mortgage with that lender are unlikely to have their rate reduced.

Many Base Rate tracker mortgages require an arrangement fee to be paid and impose an early repayment charge on full or part redemption within a specified period. In addition, the compulsory purchase of an associated insurance product may also be required.

LIBOR is the London Inter-Bank Offered Rate. It is set by the Bank of England and represents the rate at which banks borrow from each other. It is usual for several rates to be quoted, ie for three, six and nine months. Sub-prime lenders, who specialise in lending to those with an impaired credit rating, are increasingly offering mortgages on which the interest rate charged is linked to the three month LIBOR rate.

A LIBOR mortgage works in much the same way as a standard variable rate product, although the rate charged to the borrower is usually reviewed quarterly at the same time as the three-month LIBOR rate is determined. However, one advantage to the borrower is that the lender cannot arbitrarily increase the interest rate unless the relevant LIBOR rate has been increased. He is therefore protected against interest rate increases imposed at the whim of his lender, and which would apply to other variable rate borrowers.

Low start mortgages are products designed to enable the borrower to reduce the initial monthly outlay in mortgage repayments so that pressure on the household budget is reduced in the early years.

With a low start mortgage, a loan is arranged as usual on a repayment basis. However, taking a typical 25-year low start mortgage as an example, the first three years’ payments are made on an interest only basis. This reduces the cost for those early years. No investment vehicle is required, which means that, at the end of the first three years, the repayments are re-calculated to ensure that the capital and interest is repaid by the end of the original 25 years term. In effect, the borrower now has a 22-year repayment mortgage, monthly payments for which will increase significantly over those in the first three years.

These schemes have the benefit of reducing the monthly repayment in the early years, but do have drawbacks; payments will increase significantly at the end of the low start period and no capital will have been repaid. These schemes are especially useful for those on an upward career path or those who anticipate an increase in other income in the foreseeable future. For those whose circumstances change for the worse they can compound financial problems, especially if interest rates rise when the low start element expires.

An alternative low start mortgage is the deferred interest mortgage. Deferred interest mortgages were introduced during the 1980s as a way of enabling those with limited income but future greater earning potential to obtain mortgage finance during a period of rocketing house values.

These schemes defer some of the interest for an initial period – typically three years - after which the rate reverts to normal. Interest deferred in the initial period is added to the mortgage at the end of that period, and future payments will be based on the larger amount. As a consequence, the borrower pays less at the outset but more later on.

During the housing slump of the 1990s, deferred interest mortgages received ‘bad press’ and were blamed by many for the problems faced by some borrowers. Many were faced with larger mortgages, increased payments and houses worth less. Following the lessons of the early 1990s, deferred interest mortgages are now very uncommon. Any borrower considering such a mortgage should be confident that increased payments will still be affordable, and that they will be able to cope with the double blow of increases in future interest rates.

The flexible mortgage is a recent innovation in the UK. It is difficult to actually define a flexible mortgage because it can be almost anything a particular lender wants it to be.

However, to be classed as a flexible mortgage a product must incorporate the following three basic features:

The lender would normally set parameters for underpayments and repayment holidays, although these might be able to be re-negotiated in certain circumstances.

Many flexible mortgages offer far more than the basic features described above. It is common for the borrower to be provided with a chequebook to take advantage of a drawdown facility. This enables additional amounts to be borrowed and debited to the mortgage account as further advances.

The lender will set a limit on the total borrowing and, if this is exceeded, cheques are likely to be refused for payment, with no further chequebook being issued until the outstanding balance has been reduced to the required level.

This facility is much easier, administratively, than the normal method of dealing with further advances. The wording of the mortgage deed used for this type of product is such that all further advances will automatically take priority over any other charges registered against the property. Hence, the need for a subsequent mortgagee to postpone its charge in favour of the further advance is eliminated.

In addition to the drawdown facility, some lenders now offer a range of other benefits that has resulted in a particular kind of flexible mortgage, popularly called a current account mortgage.

The most important feature of a current account mortgage is the ability for it to receive salary payments and pay direct debits and standing orders in exactly the same way as a current bank account.

The borrower can also use his chequebook in the normal way and the lender is also likely to provide a debit/cheque guarantee card and, possibly, a credit card.

The main advantages of a current account mortgage are:

An offset mortgage is similar in most ways to a flexible mortgage. The main difference is that the account holder’s mortgage and savings are held in the one account. The savings held in the account are ‘offset’ against the mortgage, which means that interest is only paid on the balance. The savings are not tied into the account and can be taken out at any time.

The savings of £10,000 would be offset against the mortgage of £100,000, leaving a balance of £90,000 on which Interest would be charged. Interest would be £450 per month. Whilst no interest would paid on the £10,000 savings, the borrower would have saved £50 each month on the mortgage. Had the savings been held in a savings account at 3.5% gross, the account holder would have received £29 before tax; after basic rate tax it would be worth £23.20. Offsetting the savings against the mortgage has saved £27 a month.

While an offset mortgage sounds like a good idea, it is really of value only to those who will be able to maintain a significant and consistent level of savings in the account.

Even more sophisticated and complex offset mortgages are now becoming available. These enable a borrower to offset interest payable on various savings accounts against the interest charged on his mortgage and other secured and unsecured loans held with the lender.

The flexibility afforded by these mortgages often comes at a price. The interest rate charged may be slightly higher that the lender’s standard variable rate. However, it is becoming increasingly common for lenders to offer flexible mortgages with a fixed, discounted or capped rate for an initial period. Early repayment charges are likely to apply, and some products may incorporate an arrangement fee and/or the requirement to purchase an insurance product from the lender.

Although the number of people arranging flexible mortgages is increasing rapidly, lenders tend to regard these products as being more suitable for those who are perhaps at the higher end of the market in terms of financial awareness. At this stage in the development of flexible mortgages it is probably true to say that they are not appropriate for all borrowers.

Foreign currency mortgages were introduced when UK interest rates were very high compared to other countries. They were seen as a way of reducing mortgage costs. Now that rates in the UK, Europe, the USA and Japan are more closely aligned, they are less attractive as the savings may not be enough to justify the risks for most people. We are talking here about mortgages secured on UK property; many Britons now own second homes abroad financed with mortgages in that country – not only is that a sensible move, it is often the only choice they have if they need to raise money to buy the property.

The key points relating to a foreign currency mortgage are:

• The mortgage is arranged in a foreign currency and secured on the UK property.
• The capital owed is denoted in that currency.
• Each repayment is made in that currency – which means converting from sterling.
• The interest rate will be that applicable to the country.
• There is usually a very high minimum loan – at least £250,000 in most cases.
• Loans are usually only available on a repayment basis

£250,000 is borrowed in euros at an exchange rate of €1.45 to the pound.

The interest rate charged is 4%. UK interest rates 6.5%.

This gives a euro debt of €362,500 (£250,000 x €1.45), and a monthly repayment of €1,932. This equates to £1,332 per month.

If the dollar improved against the pound to €1.30, the following would happen:

Debt owing £278,846 (€362,500/ 1.30); monthly payment £1,486.

As you can see, movement in the exchange rates increases both the debt and the repayments, and the benefit of the lower interest rate has been eroded.

It is possible to insure against currency fluctuations, but this is expensive and will reduce savings. Some companies offer managed currency loans, where the debt is switched between currencies to gain advantage of better rates. These are still risky and cost a lot to run, again reducing the savings.

Muslims wishing to buy property are faced with a religious dilemma, as Sharia law forbids the payment or receipt of interest. This is because one party would gain at the expense of another without regard to the value of the goods traded – a concept that conflicts with the Islamic principle of equality. However, Sharia law does allow the sharing of risk and profit.

Sharia (or Muslim) mortgages have been developed to allow Muslims to raise the finance to buy property without compromising religious principles. There are two types of arrangement available.

Murabaha – with Murabaha the bank buys the property at an agreed price and then sells it immediately to the client at a higher price. The exact price depends on the repayment term, which can be up to 15 years. A first payment, typically around 20% of the property value is required, and then the client makes monthly fixed payments to the bank during the term. As the property has been transferred to the client, the property is registered in his name rather than that of the bank. Properties purchased under local authority 'right to buy' schemes cannot qualify. The Murabaha is less popular than the Ijara as it is more expensive overall and less flexible in terms of early repayment.

With both methods, Stamp Duty Land Tax is paid once, when the property is initially purchased by the lender.

From time to time lenders offer other incentives to prospective borrowers, and these may be added to any of the products described in this unit. These incentives include:

It will usually be a condition of the mortgage that some or all of the cashback must be repaid if the loan is redeemed within a given period. This facility is particularly useful for first-time buyers who may have limited savings and can therefore use the money to help meet the costs involved in the purchase or in furnishing the property.

Lenders sometimes advertise their fixed, discounted and capped rate products as being portable. This means that they can be transferred to another property when a new mortgage is taken out with the lender, but any early repayment charges are waived.

Hybrid mortgage products are a very recent innovation in the UK and offer increased protection to borrowers against future interest rate changes. For example, a borrower who has a five-year fixed rate mortgage at 5.5% has the reassurance that his monthly payment will not increase for that period, thus enabling him to budget his finances with confidence. However, if his lender’s standard variable rate is reduced on several occasions during the early stages of the five-year fixed period, then it is quite likely that his fixed rate will be rather higher than the standard variable rate, and also higher than that charged on new fixed rate products offered by that lender. He may be able to transfer to one of these new products subject, of course, to an early repayment charge being payable.

With a hybrid mortgage product, the borrower may be able, for instance, to arrange half of his loan on a fixed rate basis and half on a discounted basis. He will be protected against interest rate increases on the fixed rate element, but also be able to take advantage of any reduction in the standard variable rate on the discounted rate element. Of course, he is still exposed to increases in the standard variable rate to which the discounted rate is linked.

A number of combinations are possible with a hybrid mortgage, for example:

Some lenders may specify the ratio of each element, whilst others may be more flexible. Arrangement fees and early repayment charges are likely to apply to most hybrid mortgages, although different criteria may apply to each element. A borrower with a hybrid mortgage who is contemplating making a part redemption payment can therefore choose to apply this to that element that will incur the lowest early repayment charge.

Shared appreciation mortgages (SAMs) were introduced in the early 1990s but have now all but disappeared from the market. They were introduced primarily as a means for older homeowners to release equity in their home. Basically, a mortgage advance was arranged up to a given percentage of the value of the property. The proceeds were taken as cash of which some could be used to provide an income through the purchase of an annuity.

The rate of interest charged was reduced from the standard rate and, in some cases, no interest was charged at all. The lender would take a share in the future increase in the value of the property. For example, a 25% mortgage advance would result in the lender taking a 25% share in any increase in the value of the property.

Naturally, where property values rise at a fast rate, as they did in the late 1990s onwards, there is a risk to the borrower that the lender’s share of the increased value in the property could result in a large sum being repaid. This particular scenario led to withdrawal of virtually all SAMs from the market.

CAT-standard mortgages were introduced to give clear guarantees in respect of the charges, access and terms that are applied. They can give a degree of peace of mind to the more cautious prospective borrower.

However, a mortgage adviser should always point out to a client who is adamant that he wants a CAT-standard mortgage that such a product may not necessarily be the most appropriate one for him.

A mortgage intermediary is not permitted to charge his client a fee if a CAT-standard product is being recommended.

The criteria in respect of charges, access and terms vary slightly between different mortgage products. They are summarised as follows

For all variable, fixed and capped rate mortgages these are:

The following criteria relating to charges apply only to variable rate loans:

Other charges criteria for fixed and capped rate loans only are:

The following criteria in respect of access apply to the full range of mortgage products:

The following criteria in respect of terms apply to the full range of mortgage products:

Apart from the mortgage products already described, there are a number of other mortgage schemes that are also widely available. These include:

An equity share scheme enables the borrower to obtain a lower rate of interest in return for giving the lender an equity stake in the property.

A number of different schemes have been introduced during the past 20 years, but a typical one would involve the borrower paying the standard variable interest rate on, say, 70% of the agreed loan and either a reduced rate, or even no interest at all, on the remainder of the loan.

In return for this concession, the lender might take a 20% share of the equity in the property when it is sold.

Such a scheme appeals mainly to first-time buyers who may be borrowing at the maximum and who wish to keep their monthly payments to a minimum.

However, there are drawbacks, eg if the original loan-to-value ratio was high and property price inflation has remained low for some time since the purchase was completed, it may make it difficult for the borrower to trade up in the property market as the already limited equity will be further reduced when the lender takes its share.

These schemes were first developed in the late 1970s through co-operation between housing associations, local authorities and mortgage lenders.

They are designed to help people on a low income who are not able to obtain a conventional mortgage elsewhere. The scheme combines rental payments to a housing association or local authority with mortgage payments to the lender. The total outgoings are less than for a standard mortgage.

An applicant is carefully vetted by the housing association or local authority to ensure that he fulfils all the relevant criteria. He is then referred to the lender with which the housing association or local authority is working, who also assesses the applicant in the normal way before agreeing to consider a mortgage application. In some instances, a local authority may put forward applicants who have been on the housing waiting list for more than a specified period.

It is usual for an individual to purchase only a 25% or 50% share of the property and rent the remainder from the housing association or local authority. A process of ‘staircasing’ enables further shares in the property to be purchased when income is sufficient to meet the increased payments.

The staircasing process can work in reverse. Some mortgage rescue schemes operate by enabling owner-occupiers with serious payment difficulties to sell a share in their property to a housing association.

The rent charged is kept as low as possible so that the total outgoings are not much more than they would be for renting a property in the normal way. The borrower is responsible for all property maintenance, apart from common areas in a block of flats. Stamp duty is payable on the full price of the property, not just on the share being purchased.

The situation may then be reached where the borrower owns 75% of the property and makes rental payments on the remaining 25%. Some schemes will allow the property to eventually be purchased outright, whereas others impose a limit of, say 75% on the share that can be owned.

When the property is eventually sold, the equity is split between the vendor and the housing association or local authority according to the share of the property that is owned and the proportion that is rented. If the property is not owned outright by the vendor, then he may be required to offer it back to the housing association or local authority, which will then find a suitable purchaser from its own list. In many instances, however, the vendor may be allowed to sell the property on the open market.

In recognition of increases in house prices, and the difficulty some borrowers have in putting together a large enough deposit, many lenders offer 100% and even 125% mortgages.

The mortgage will be based on the lender’s normal income multiples, perhaps with a little more generosity, as it is important that the borrower is not over-stretched financially. There will usually be some form of high lending fee or Mortgage Indemnity Guarantee required; this can often be added to the loan.

The range of options available may be limited, although borrowers have relaxed their approach in view of the competitive marketplace.

Some lenders have developed mortgages where up to 125% of the property value is available.

This is achieved by arranging a package with a 95% mortgage and an additional 30% on an unsecured basis. The whole loan will be at the relevant mortgage rate and repayable over the standard mortgage term. Many lenders will allow partial repayment without penalty.

Borrowers considering 100% and 125% mortgages should bear in mind that they will have no equity in the property for a period, and that falls in property prices will leave them with negative equity. Those who can put down a deposit of at least 5% will usually have a wider range of mortgage options.

This legislation is included in the Housing Act 1985, revised in the Housing Act 2004, and enables a secure tenant of a District Council, a London Borough Council or a registered social landlord to purchase his property at a discounted price. For the purposes of the right to buy legislation, there are two categories of tenant. Those whose secure tenancy started before 18 January 2005, who we will refer to as existing tenants, and those whose tenancy started on or after 18 January 2005; these are called new tenants.

The basic rules for existing tenants are:

• those who were in a secure tenancy before 18 January 2005 gain the right to buy their property after two years of that tenancy;
• the discount after two years is 32% for houses and 44% for flats;
• those buying houses qualify for a further 1% for every additional year of tenancy, up to a maximum of 60%;
• those buying a flat qualify for a further 2% for every additional year of tenancy, up to a maximum of 70%.

In addition to the limit of 60% or 70% discount, the Government imposes a monetary limit on the actual amount of discount that can be given by the landlord. This amount varies from region to region and means that a tenant may not necessarily be able to claim the full discount to which he thought he was entitled. At present, the maximum discount in monetary terms ranges from £16,000 in the London area to £38,000 in some other parts of the UK. The limits are intended to reflect the level of housing stock available in the region.

If the tenant sells the property within a certain period, some or all of the discount may be repayable. The amount depends on when the right to buy was exercised.

Sold during the first year after exercising the right – 100% of the discount must be repaid

Sold during the second year after exercising the right – 2/3rds of the discount must be repaid

Sold during the third year after exercising the right – 1/3rd of the discount must be repaid

After three years – no repayment

The amount repayable will be a percentage of the actual discount received

Sold during the first year after exercising the right – 100% of the discount must be repaid

Sold during the second year after exercising the right – 4/5ths of the discount must be repaid

Sold during the third year after exercising the right – 3/5ths of the discount must be repaid

Sold during the fourth year after exercising the right – 2/5ths of the discount must be repaid

Sold during the fifth year after exercising the right – 1/5ths of the discount must be repaid

After five years – no repayment

The amount repayable will be a percentage of the resale value (less any improvements made)

Those who exercised the right on or after 18 January 2005 who wish to sell within ten years of exercising the right must offer it first to their former landlord or another social landlord at full market price.

Most lenders will consider mortgage applications from tenants wishing to purchase under the right to buy legislation. Lenders’ attitudes vary – some will lend based on the market value of the property, whilst others will base lending on the discounted price.

The valuer will also look carefully at the location of the property and how, in particular, this might affect its resaleability. An owner-occupied property that is situated in a road or area where almost all other properties are still tenanted may have limited appeal.

A buy-to-let mortgage scheme is designed to enable an individual to purchase a property for investment purposes, ie for letting rather than for owner occupation. Consequently, such schemes are not regulated by the Financial Services Authority.

These schemes have grown considerably in popularity over the past few years. This is due mainly to an increasing number of people wishing to take advantage of the continuing rise in property prices and the shortage of property for rent in the private sector.

In addition, the rental income and possible capital gain to be realised when the property is sold represent an alternative investment to equities, which have fallen markedly over the past few years.

A buy-to-let mortgage presents a greater risk to the lender because:

Initially, lenders offset this increased risk by charging a higher rate of interest than for conventional mortgages. However, as the demand for these schemes has grown interest rates have fallen. There are now many buy-to-let mortgages available on a fixed or discounted basis. These products usually incorporate an arrangement fee and an early repayment charge.

Lenders do not usually employ income multiples when deciding how much to lend a buy-to-let applicant. The amount of the advance is usually calculated on the basis of the anticipated monthly rental income being around 125% of the monthly payment on the loan. If the applicant owns his main residence outright and has no other mortgages, then affordability may be assessed in the conventional way by applying a prescribed multiple to his income.

The lender will also want to ensure that a suitable form of tenancy agreement is used so that it is not prevented from obtaining a possession order in the event of default. It is usual for an assured shorthold tenancy agreement to be drawn up as this also gives the landlord the right to take possession of the property when the lease expires.

Before deciding to proceed with a buy-to-let application the individual needs to assess the proposition carefully. Information on the local rental market should be sought and a reputable letting agent should be appointed to manage the tenancy.

The rapid growth in the buy-to-let market is beginning to cause some concern. In some areas of the country it is becoming increasingly difficult to find suitable tenants and more properties are now remaining empty for longer periods. The situation would be made worse if property prices started to fall following the lengthy period during which they have risen dramatically.

There are a number of specialist plans designed to release capital or income for elderly homeowners. Some of these schemes involve mortgages – known as lifetime mortgages, and some involve the sale of the property to a provider in exchange for a benefit. This section will look at the schemes available.

First a definition - the FSA has established a special mortgage category, known as ‘Lifetime Mortgages’. The FSA defines these as mortgages where:

• They are available only to borrowers over a certain age;
• No capital or interest payments are required during the life of the mortgage, although interest accrued can be ‘rolled up’ and added to the debt
• The mortgage is repaid only in the event of the borrower’s death, a move into residential care or sheltered accommodation, the borrower moving to another property or the borrower choosing to repay the loan

These plans are designed mainly to enable elderly homeowners who do not have a mortgage on their property to release some of the equity in order to provide capital or supplement their retirement income. Most of the schemes are available only to property owners over the age of 60, and many have a minimum age of 70. While aimed at those who do not have a mortgage, these schemes are also available to those with small mortgages, although the prior mortgage would have to be paid off as part of the arrangement.

With a Home Income Plan (HIP), the homeowner takes out a mortgage on their home. The lender will restrict the lending, usually from around 25% to 55% of the property value, depending on the borrower’s age. Because the property is being re-mortgaged, the loan is covered by mortgage regulations.

The capital released in this way can be used to provide an annuity, or invested in an income producing vehicle, or as capital to meet the borrower’s needs.

Before the abolition of Mortgage Interest Relief in 1999, many of these schemes used the capital raised to buy a lifetime annuity for the borrower, which provides a guaranteed level of income. The mortgage interest rate was fixed and monthly interest payments were deducted from the annuity income. The effect of mortgage interest relief meant that the borrower was still able to receive a reasonable surplus income from the arrangement and no interest was rolled up – the debt remained the same. The abolition of tax relief and reductions in annuity rates changed the maths and the surplus income levels became unattractive. Those who entered a HIP on or before 8 March 1999 will still qualify for interest relief at 23% on the first £30,000 of the loan.

Earlier versions of the plan, marketed in the late 1980s and early 1990s did not arrange an annuity, instead they encouraged the borrower to buy an investment bond with the capital raised, using the growth on the bond to provide an income. Unfortunately, problems occurred:

• interest rates were usually variable and increased considerably during that period;
• property values started to fall at about the same time;
• growth and income from equity based investments fell.

People who found themselves in this situation did not have the benefit of regulation to protect them, as HIPs did not come under the remit of the regulator; neither did they benefit from the safeguards and protection offered by the Safe Home Income Plans (SHIP) trade association, a later development. The result was that many borrowers found themselves with either negative equity or insufficient income to meet the loan payments – or both.

On the vast majority of modern HIPs, no interest payments are made to the lender during his lifetime. Instead, interest is allowed to roll-up and is repaid, along with the original loan, when the property is sold on the death of the borrower, or the borrower decides to move. Clearly, a 60-year-old borrower is likely to accumulate considerably more unpaid interest over the rest of his life than a 70 year old. Hence, the younger one will not be able to borrow such a high percentage of the value of his property as the elder.

In recent years, the main providers of home income plans have joined together and formed a trade association called Safe Home Income Plans (SHIP). This has established a Code of Practice designed to safeguard the interests of borrowers. The main safeguards are:

On a drawdown mortgage, a maximum lending limit is agreed by the lender. The borrower is then able to draw from the available funds as and when he chooses. Interest is charged on the amount outstanding, but is rolled up rather than paid each month. The benefit of this type of loan over a Home Income Plan is that interest only accrues on the amount actually borrowed, so the borrower has a degree of control and the debt is unlikely to increase as rapidly.

These schemes are an alternative to home income plans and involve the homeowner selling all or part of his property to the lender in return for a capital sum. The original owner then enters into a lifetime lease agreement with the provider, usually at a nominal annual rent, which guarantees him (them) lifetime occupation. No interest is charged because there has actually been a change of owner rather than a mortgage created.

The provider decides how much to give the homeowner in return for the property (or share); this is based on estimates of life expectancy. The provider will take a higher proportion of the property value than that represented by the cash released – for example, on a house worth £100,000, £35,000 – £40,000 might be released. If the same homeowner wished to sell 50% of the property, £17,000 – £20,000 might be available. This is to allow for the fact that no interest will be charged and the provider will have to wait for the death of the borrower(s) to receive most of the profit.

The capital can be used as the homeowner wishes. As an alternative, some schemes use the cash released to buy an annuity, thereby increasing the individual’s income.

As no mortgage is created, these schemes are not covered by mortgage regulations. There is a strong lobby for the regulation of these schemes, as they do not currently fall under any regulatory regime; regulation appears likely in the near future.

As the provider takes full ownership of the property (or part of the property), no interest payments are made by the ‘tenant’. The provider eventually sells the property and retains all the proceeds from the percentage of the property it owns. Where only part of the property is held in the plan, the provider will retain that percentage of the property value when it is sold. For example, if 50% of the property is sold to the provider, 50% of the final proceeds will be retained by the provider and 50% passed on to the estate.

Most home reversion schemes are covered by the SHIP Code of Practice and offer the same safeguards as home income plans.

There are potential pitfalls with all the schemes described above. There are many happy pensioners who have taken advantage of the schemes – they have seen their living standards improve and have money to spend. Unfortunately, the problems only surface when they decide to move or they die. They include:

• the family’s inheritance has gone;
• the individual is unable to move or has less capital than he wanted.

For these reasons it is important that the homeowners and their families know exactly what they are doing and exactly what the scheme does. The adviser should always ensure that members of the family are involved in the process. If all are clear on the advantages and disadvantages of such schemes, problems will be avoided.

A partnership, also sometimes known as a ‘firm’, is an arrangement between people carrying on a business in common. Unlike a company, it is not a separate legal entity, and the assets (and liabilities) of the partnership are jointly owned by the partners themselves. Therefore, a lender will not only need to look at the partnership business itself as a credit risk, but will also look behind it to the financial good standing of the partners.

Because the partnership is no more than an arrangement between its partners, it may – unless specific provisions are made to the contrary in the partnership deed – terminate on the death or bankruptcy of any one partner. Therefore, lenders will take particular care both in assessing a partnership proposition at the outset, and in its dealings with it on an ongoing basis.

Corporate borrowing – ie where the money is lent to a company – may be for either residential or commercial purposes. In either event, the loan will be assessed as usual, in terms of the security being offered and the borrower’s ability to pay. However, because the borrower is a company and not an individual, and because it is a separate legal entity from its shareholders, there are some additional considerations.

Loans to corporate and semi-corporate businesses can represent potentially HIGHER MARGINS for the lender and sometimes involve GREATER RISK.

Although banks can, and do, lend considerable funds to limited companies, building societies are restricted under the provisions of the Building Societies Act 1986, (as amended by the Building Societies Act 1997), in respect of corporate lending. A maximum of 25% of commercial assets can be held in loans to limited companies secured on land.

The credit assessment process for corporate and semi-corporate borrowers is invariably more complex than that for personal borrowers, requiring an understanding of how to interpret formally prepared financial accounts, for example.

A commercial mortgage is one where the security for the loan is a commercial property (eg a shop or a factory) as opposed to a residential one. A commercial mortgage could be made either to an individual or to a company. When assessing a request for commercial lending, the lender will consider both the status of the borrower (often the company) and the viability of the lending proposition. The assessment will include the borrower’s track record in running the business (or a similar business), the business plan and the expected impact of buying the property – increased capacity and so on. Where it is intended to rent the property, the assessment will include the type of tenant, the length of their lease, the type of the contract and the likelihood of getting a replacement tenant if necessary.

Section 3

Other mortgage-related products

It is vitally important to both the lender and the borrower that the mortgaged property is adequately insured. For the lender, the property is the prime security for the loan that has been made and it is essential that it is insured against any event that would adversely affect its value. Similarly, the borrower needs to protect his home.

From the lender’s point of view, insurance of the property’s contents is not so critical. The borrower, however, should insure his contents, although not all do by any means. Combined policies have become much more common in the past 15 years or so.

Many buildings insurance policies nowadays are index-linked. This means that the level of cover that is put in place at the outset is automatically increased annually in line with a recognised index that reflects increases in house-building costs. The chances of under-insurance are therefore considerably reduced.

However, it is now quite common for a policy not to actually provide a suitable level of cover for a particular property, but instead to insure it for an upper limit of, say, £500,000. This will apply to a large number of properties insured by a company and ensures that each property is never likely to be under-insured. For larger and more expensive properties, it will be necessary to determine a specific level of adequate insurance cover.

Because of the importance of buildings insurance, the lender has the right to:

These rights are usually explained in the mortgage deed.

The following standard perils are covered by almost all policies:

For an additional premium, cover can usually be provided for the accidental breakage of fixed glass and sanitary fittings.

Most policies also cover the cost of:

Some of the standard perils carry an excess. This means that the borrower has to pay a specified amount of each claim.

All policies also carry exclusions, ie specific types of damage that are not covered. Standard exclusions include:

Under-insurance is not so much of a problem now as it has been in the past, particularly with the increasing number of index-linked policies available from insurers.

It may not become apparent that a property is under-insured until a claim is made. In such cases, the insurer is unlikely to meet in full any claim that it has agreed to accept, and will apply the principle of averaging, ie reduce the claim payment in proportion to the level of under-insurance.

A property has an insurance valuation of £180,000 but it is actually insured for £150,000. If a claim for £15,000 is submitted and a standard excess clause of £500 applies, the amount that the insurer will pay will be calculated as follows

£150,000 x £15,000 = £12,500 – £500 = £12,000

£180,000

Many lenders operate a block buildings insurance policy arrangement. The cover provided and premium rate are agreed between the lender and the insurer, but instead of issuing each borrower with an individual policy number a master policy is set up, with both the lender and insurer having copies.

As each mortgage is completed, the relevant property address and borrower details are sent to the insurer. A document setting out which risks are and are not covered and how to make a claim is sent to the borrower immediately after the mortgage is completed.

A lender will have a block policy arrangement with a number of different insurers, primarily because the Office of Fair Trading has stated that the borrower should be given a choice of at least three insurers. It is usual that exactly the same standard of cover and premium rates are offered by each insurer.

The block policy arrangement offers benefits to both the lender and the borrower. For the lender, the advantages are:

The advantages of a block policy arrangement to the borrower include:

Some properties may be excluded from cover under a block policy, eg those of non-standard construction and those which have a particularly high value. Commercial and semi-commercial properties are also usually excluded.

Apart from the choice of block insurer that must be given under the Office of Fair Trading guidelines, the borrower now also has a right to choose his own insurer from the wider marketplace.

However, even here the lender has some say in the matter and is entitled to inspect the proposed policy to ensure that it meets its minimum requirements. In addition, the insurer must be one that is recognised as being reputable by the lender. Most lenders would probably not accept a policy issued by an insurer that is not a member of the Association of British Insurers – the official trade body for the insurance industry.

The increasing numbers of borrowers who have exercised their right to choose their own insurer has resulted in lower levels of commission being received by lenders. This is perhaps more serious for the small and medium-sized building societies, but all lenders now generate commission income by selling a whole range of mortgage-related products.

The risk to the lender is increased where agreement is given to the borrower to arrange his own insurance. The lender will therefore request that:

To cover the cost of this additional administration most lenders charge the borrower a one-off fee, usually around £25.

Neither the lender nor the borrower usually have much say in the arrangements made for insuring a leasehold property. This is because the freeholder will probably have organised cover through his own insurer and included all relevant details in the lease. This is more often than not the procedure that is followed by the freeholder of a block of flats. Only one policy is taken out covering the whole building, with the cover relating to each individual flat being shown on the policy schedule.

In the case of an individual leasehold house or bungalow, the freeholder may be content to allow the lender or borrower to arrange their own insurance cover, although he may want to approve the policy and have his interest noted on it.

Where the freeholder insists on arranging the insurance cover the lender is in a difficult situation if the policy does not meet its minimum requirements. This may mean that any offer of advance made to an applicant has to be withdrawn if the freeholder will not agree to arrange improved cover to satisfy the lender. The wishes of the freeholder therefore take precedence over those of the lender.

If the policy is acceptable, the lender will wish to safeguard its interest in the property by asking for its name to be noted on the policy and to be kept informed of any lapse in the payment of premiums or submission of a claim. Of course, the lender will be reassured that the freeholder will be equally as concerned that the property is adequately and continuously insured.

The borrower will normally be required to pay buildings insurance premiums on a half-yearly basis direct to the freeholder, along with service charges and ground rent.

It was mentioned earlier that claims made under a block policy arrangement are often handled initially by the lender. For all other policies, claims are handled entirely by the insurer.

A borrower whose property is insured under a block policy can elect to switch to an insurer of his own choice at any time. The normal procedure that has been described earlier will be followed by the lender. If agreement is given, the lender will probably charge the usual one-off fee.

Occasionally, a borrower may seek confirmation that his property is adequately insured. This will be referred to a valuer for his recommendation. If an increase is found to be necessary under a block policy, an appropriate increase will be made to the premium.

Property insurance premiums are subject to a 5% insurance premium tax.

A mortgage protection policy is designed to cover the repayment of a mortgage in the event of a borrower’s death. These products are referred to as term assurances, the main ones being decreasing, level and convertible.

All these products share the same characteristic, ie the sum assured is payable only on the death of the life assured within the policy term. If the policyholder survives to the end of the policy, the policy lapses and there is no return payable. In other words, term assurances provide only protection and do not contain any element of investment.

In general, term assurance provides the most basic and cheapest form of life assurance. Any policy can be taken out on one or more lives, and it is quite usual for joint borrowers to arrange a joint policy to pay out the sum assured on first death, thus protecting the surviving borrower.

The most common form of decreasing term assurance is a mortgage protection policy used in conjunction with a capital repayment mortgage. The sum assured decreases annually in line with the reducing mortgage balance and the policy therefore guarantees to fully repay the outstanding debt, provided that premiums have been maintained and the mortgage account is not in arrears. Premiums are fixed at the outset and remain unchanged throughout the policy term.

The benefit payable under this type of policy is based on a maximum rate of interest being charged on the borrower’s mortgage. If this rate is exceeded, there is no guarantee that the loan would be fully repaid on death. However, most insurers now set the maximum interest rate at a sufficiently high level so that the chances of a shortfall are extremely remote.

The advantages of using a decreasing term assurance policy to protect a mortgage are:

With this type of policy the sum assured remains constant throughout its term. The premium is fixed at the outset and also remains unchanged.

The cost is marginally more than for a decreasing term assurance policy, but some borrowers prefer the level term policy in protecting a capital repayment mortgage. This is because there would be a surplus available after the mortgage has been repaid which would benefit the surviving borrower.

Level term assurance is incorporated in a unit-linked endowment policy, thereby guaranteeing to fully repay an interest-only loan on the death of the borrower.

Level term assurance will also usually be arranged by a borrower who is using an ISA or personal pension plan as the mortgage repayment vehicle, as neither of these products have any built-in life cover.

This is a level term assurance policy that provides an option to convert it into whole-of-life or endowment assurance at a later date, without the need for the policyholder to make a further health declaration. This option means that the premium would be around 10% to 15% higher than for a conventional level term policy.

The option can normally be exercised at any time during the term of the policy. The revised premium will be based on the policyholder’s original health declaration, but on his age at the time the request to convert the policy is made.

The conversion option usually allows the term of the policy to be extended if the policyholder wishes, but the sum assured cannot be increased.

Convertible term assurance policies are relatively rare nowadays, but they can be an attractive option for first-time buyers on limited incomes who cannot afford endowment premiums at present, but who do need to protect their mortgage. There is flexibility in that the option need never be exercised and the policy can simply remain as level term assurance.

It is possible to arrange level term assurance within a personal pension arrangement – known as Personal Pension Term Assurance (PPTA). This will allow the plan holder to benefit from income tax relief on premiums in the same way as on pension contributions. The amount of PPTA that can be purchased is limited by the contribution allowed, which depends on when the pension contract was arranged.

• For plans taken out before 6 April 2001, the maximum premium payable in any one year is 5% of net relevant earnings. The premium is included in the maximum age-related contribution that can be made to the plan.
• For plans taken out on or after 6 April 2001, the maximum premium that can be used to purchase PPTA is limited to 10% of the gross contributions made to the pension plan. Again, these premiums count towards the overall age-related contribution limit.

An MPPI policy covers the borrower’s mortgage payments for a period of up to two years if he is unable to work due to accident or sickness, or has been made redundant. It is therefore sometimes called accident, sickness and unemployment insurance, although this is not a particularly accurate description as unemployment is only covered if it results from involuntary redundancy.

An MPPI policy does not provide any life cover and usually allows more than one claim to be made provided that premiums are maintained. Its key features are:

These include:

The earliest MPPI policies contained so many exclusions that it was often difficult to get a claim accepted. The need for mortgage payment protection became more urgent after the Income Support for Mortgage Interest (ISMI) Regulations were amended for all new mortgages completed after 1 October 1995. These borrowers have to wait 39 weeks from the acceptance of a claim before any benefit is payable.

Lenders are not always prepared to wait this length of time before any payments are received and may decide to commence possession proceedings before the 39 weeks have elapsed. The waiting period for borrowers whose mortgages were completed before 2 October 1995 is eight weeks for the payment of 50% of benefit and a further 18 weeks for payment of the full entitlement.

The government strongly encourages borrowers to take out MPPI and discussions with the main providers and the Association of British Insurers has resulted in most policies now having standardised, and fewer, exclusions and restrictions. Although many more borrowers do now have MPPI, there is still a large number who do not.

A PHI policy provides a monthly tax-free income when the policyholder is unable to work due to accident or sickness. It does not cover redundancy or unemployment.

It is regarded as being permanent as there is no limit to the number of claims that can be made while the policy is in force. The insurer cannot cancel the policy or increase the premiums simply because several valid claims have been made and met.

Unlike an MPPI policy, the period for which benefit may be paid is not severely restricted. It will continue to be paid until the policyholder is able to return to work, retires or dies, whichever event happens first.

Benefit payments normally commence after a deferred period agreed at the outset by the policyholder. The deferred period is usually between 4 and 52 weeks. The longer the period the lower the premium payable.

The choice of deferred period by an employed person may be influenced by the length of time that his employer will continue to pay his full salary in the event of sickness. For example, if full salary will be paid for the first three months of sickness, then the minimum deferred period should be for the same period. A longer deferred period will further reduce the premium and may be selected according to the insured’s financial situation and ability to maintain mortgage payments and meet other essential expenditure from savings.

The monthly benefit is not intended to fully replace lost earned income, as there would then be no incentive to return to work. The usual maximum level of benefit is approximately 60% of the insured’s average net monthly income, thus allowing account to be taken of entitlement to any state benefits as well as payments received from other income protection policies held. The 60% maximum benefit applies to the total benefit received from all PHI policies held by an individual. The existence of any other policies must be declared when a proposal for a new policy is made and also when any claim is made.

There are instances where a person returning to work following illness is unable to continue in the same job. This may mean being transferred to less onerous duties on a lower salary, and in such circumstances a PHI policy will pay a proportion of the maximum possible benefit to make up the reduction in salary. The same principle would be applied if the policyholder were forced to give up full-time employment for part-time employment. However, these benefits are only available if the policy has been written on an ‘any occupation’ basis.

The level of premium payable is based on a number of factors, eg:

Some occupations carry a greater risk than others. For example, an office worker would be regarded as a much lower risk by the insurer than a scaffolder. Hazardous pastimes such as parachuting and pot-holing will also have the effect of increasing the premium.

Policy exclusions tend to vary between PHI providers, but the usual standard exclusions are:

An individual proposer can reduce the premium payable by requesting that other specific exclusions are stated in the policy document.

Many employers now offer group PHI schemes and pay the premiums on behalf of their employees. However, the Inland Revenue regards the provision of such schemes as a taxable benefit-in-kind as far as the employees are concerned. Premiums are generally cheaper under group schemes than they would be if each employee arranged his own individual policy. This is due to economies of scale. A major advantage of a group scheme is that each member is entitled to a certain level of cover that does not depend on a health declaration. This is particularly beneficial to those who would have difficulty arranging their own policy because of poor health.

This product pays a tax-free lump sum on the diagnosis of any one of the serious illnesses specified in the policy. These generally include:

However, it is usually the case that none of these illnesses are covered if they are related in any way to HIV or AIDS. In addition, any illness of which the insured was aware when the policy was arranged would also be excluded.

The lump sum benefit is paid only if the policyholder survives for a specified period, usually 28 days, from the date of diagnosis. The benefit does not have to be repaid even if a full recovery is made from the illness. However, it can only be paid once, after which the policy is cancelled.

Critical illness insurance can be either a stand-alone policy or as an ‘add-on’ to an endowment or term assurance policy. In the latter cases, the lump sum is payable either on diagnosis of one of the prescribed illnesses or on death, whichever occurs first.

The main benefit of this type of policy is that it can be used either to fully repay or partly repay an outstanding mortgage, or replace lost income during a lengthy period of sickness.

Many protection policies now offer a waiver of premium option. This is designed to ensure that the policy benefits are preserved if the policyholder is unable to continue paying premiums because of ill health. If chosen, this option will mean a slightly higher premium being charged, but it is particularly beneficial for the self-employed whose income is likely to cease almost immediately if they are unable to work.

It is usual that, in the event of a claim being made, a deferred period of at least 13 weeks must elapse before the waiver option takes effect.

A mortgage indemnity guarantee (MIG) is a single premium policy that is sometimes arranged by a lender if the loan-to-value ratio exceeds a certain level. This threshold varies from lender to lender but is usually between 75% and 90%. The policy is regarded as additional security because it protects the lender in the event of a property being taken into possession and sold for less than the outstanding debt. Although the premium is usually paid by the borrower, the policy does not actually benefit him, except that without it he would be unlikely to be able to borrow such a high proportion of the value of the property. Under the Mortgage Conduct of Business (MCOB) Rules the premium for a MIG policy must be described to applicants as a higher lending charge, not simply as a MIG premium.

Some lenders allow the higher lending charge to be added to the advance rather than having to be paid up front. In recent years, more and more lenders have met the cost of the MIG policy themselves or even dispensed with this form of security altogether. This is one of a range of incentives that lenders now offer to attract new mortgage business.

If a successful claim is made by a lender on a MIG policy then the insurer is entitled to exercise its right of subrogation, ie to sue the borrower for recovery of the amount paid to the lender under the claim. An insurer has the right to impose a 20% excess on any MIG claim made without having to give a reason. A claim can be declined outright if the insurer has reason to believe that the lender had not applied sound underwriting principles when approving the loan.

A mortgage applicant is hoping to borrow £100,000 to purchase a property priced at £115,000 but valued at £110,000. The lender makes a higher lending charge if the loan-to-value ratio exceeds 80%.

£110,000 x 80% = £88,000

The amount of the advance on which the higher lending charge will be based is therefore £100,000 – £88,000 = £12,000.

If the premium rate for the policy is 4.5%, the higher lending charge will be

12,000 x 4.5 = £540

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