Mortgage payment methods and products

After studying this unit, you will be able to demonstrate an understanding of:

Section 1

Mortgage repayment methods

Although there are many mortgage products currently available, there are only two mortgage repayment methods: 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.

Section 1 describes the capital and interest and interest-only methods of arranging a mortgage, as well as the different repayment vehicles for interest-only mortgages.

Section 1 covers part 1 of the syllabus for Unit 5.

Until the mid 1970s, capital repayment – or capital and interest – this was the conventional method of repaying a mortgage. Interest-only loans then became prevalent, 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; the interest part of each monthly payment decreases, while the capital element increases.

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 above example illustrates 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 inbuilt flexibility. 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 this 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.

The following table shows the capital outstanding at points in the term of a 25-year £100,000 repayment mortgage. The figures assume interest rates will not change over the term.

The main disadvantage to capital repayment is that there is no built-in life cover. This must be arranged separately, although decreasing term assurance cover is generally inexpensive. The main advantages are as follows.

The same principle as that in the above example will apply where the borrower chooses to maintain or reduce payments when rates increase, although underpayments will result in an extended term. This will be of benefit to those who are struggling to meet their mortgage payments and cannot afford an increase. Alternatively, reducing the payments and extending the term can be of temporary benefit to those who are finding it hard to meet their mortgage payments, perhaps through unemployment or ill health.

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 repay the associated mortgage in full. 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 repay the loan in full 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.

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:

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 must 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:

On a guaranteed sum assured of £50,000, with an end of year 1 bonus declared at 3%, the reversionary bonus added will be £1,500. GSA is now £51,500. At the end of year 2, a bonus is declared 2% – reversionary bonus added will be £1,000, and the GSA now be £52,500.

On a GSA of £50,000, with an end of year 1 bonus declared at 3%, the reversionary bonus added will be £1,500. The GSA is now £51,500. At the end of year 2, a bonus declared of 2% – reversionary bonus added will be £1,030 (£51,500 x 2%) and the GSA is now £52,530.

On a GSA of £50,000, with an end of year 1 bonus declared at 3%, the reversionary bonus added will be £1,500. The GSA is now £51,500. At the end of year 2, a bonus is declared of 2% on GSA and 1.5% on accrued bonuses. Bonus – on GSA, £1,000; on accrued bonuses £22.50.

The full with-profits 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 in an easier 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, because no further premiums will be paid.

The advantages of the full with-profits endowment are that:

The disadvantages of the full with-profits endowment are that:

The low-cost with-profit endowment policy was developed in the 1970s as a more affordable alternative to the full with-profit policy. Over the next two decades, it 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 advantages of the low-cost with-profits endowment are that:

The disadvantages of the low-cost with-profits endowment are that:

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 that the fund is built up.

Premiums buy units in one or more of a range of unit-linked funds. Not all of the premium is invested because 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, because growth (or loss) 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 ten years, has a death benefit of £75,000 and a current unit value of £25,000. If the policyholder dies, the death benefit will 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 (a mortality charge), 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. The plans are flexible, however, and it may be possible to increase or decrease the premiums, or to extend the term, subject to the policy rules and qualifying rules.

The charges on a unit-linked plan are clearly laid out in the policy document. Typically, they will include:

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 ten, 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-profits 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:

The advantages of the unit-linked endowment are that:

The disadvantages of the unit-linked endowment are that:

• The final value is not guaranteed, and unit values can go down at any time as well as up;

• High charges on some policies can reduce the growth made.

Unitised with-profit endowment 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), which means that 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 must 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 repay the mortgage in full on maturity is 6% or less, then the policyholder is advised that no action is necessary, but 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’.

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

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 must be taken if it is felt that there are grounds for a valid complaint. These grounds are if:

Although relatively uncommon, it is possible to use unit trusts and OEICs as mortgage repayment vehicles. As both these vehicles can be held within an ISA, it is more tax efficient, and more common, for them to be used as part of an ISA repayment ‘package’.

A unit trust is a pooled (or collective) investment created under trust deed. The term pooled is used because money from a large number of investors is pooled together and then invested. An investor can invest in a unit trust through a lump sum, regular contributions or both.

The unit trust is divided into units, with each unit representing a fraction of the trust’s total assets. In simple terms, the value of each unit is the value of all of the trust’s assets divided by the number of units issued. A unit trust is open-ended in the sense that a manager can, in response to demand, create more units. He is also obliged to buy units back from investors wishing to sell.

The unit trust is set up under a trust deed, which means that the assets are separate from the company that runs it. The deed specifies the types of investment the manager can use, the broad principles on which it can operate and whether it pays income or aims for growth: this is referred to as the mandate. For example, a typical Japanese unit trust’s deed might specify that at least 85% of the fund must be invested in Japanese shares.

The main role of the unit trust trustee is to hold the fund assets on behalf of investors and to ensure that the trust runs in line with its deed.

The role of the unit trust manager is to manage the investments, value units and buy and sell units on demand. Most unit trusts are actively managed, which means that the manager carries out research on suitable investments and buys and sells investments to achieve the required fund objective.

There are over 2,000 unit trust and OEIC funds available in the UK. The Investment Management Association (IMA) has defined three broad categories.

The objective of growth unit trusts is capital growth. The underlying investment is in shares and other assets likely to benefit from growth, while not likely to produce significant income. Any income received from underlying assets is automatically reinvested into the fund, thus increasing the value of each unit – hence the term accumulation.

Typically a distribution unit trust's underlying investments will feature high-yielding shares, gilts, bonds and cash.

The individual investor can choose to take the dividends or reinvest them by purchasing new units, as opposed to increasing the value of existing units.

The fund is not actively managed as such; the manager only needs to make sure the index is replicated in the shares held. This keeps the fund charges down compared to actively managed funds.

Units are purchased at the offer price. An initial charge is taken from the units when they are purchased, typically 3–5% of the purchase value. The charge is taken to cover, among other things, the cost of purchasing assets and paying commission to advisers.

Once units have been purchased and the initial charge taken, they are valued at the bid price, which is the price at which they can be sold back to the manager. The difference between the bid price and the offer price is known as the bid-offer spread.

To give a simplified example, an investor invests £1,000 pounds in a unit trust with a unit offer price of £1 and an initial charge of 5%. Once the initial charge has been taken he will still own 1,000 units, but the bid price will be £0.95, leaving him with a holding worth £950.

Unit trusts are subject to a fund management charge – the fee paid for the services of the professional investment manager. The charge will vary but is typically in the region of 0.5% and 1.5% of fund value.

Dividends from a unit trust are taxable as non-savings income, depending on the source of the underlying income.

Gains made on disposal of a unit trust holding are subject to capital gains tax.

OEICs are pooled investments that operate in a similar way to unit trusts. However, their legal status is different - they are set up as limited companies. This means that investors buy and sell shares in the OEIC. As with a unit trust, the share price represents the value of the fund assets divided by the number of shares in issue. The OEIC manager is obliged to buy back shares from investors who wish to sell, and is able to create more shares on demand. This makes the OEIC an open-ended fund, in line with unit trusts.

As OEICs are similar to unit trusts, the Investment Management Association (IMA) uses the same categories as for unit trusts. Most investment performance-rating organisations combine unit trusts and OEICs in the same tables.

The depositary carries out a similar role to the unit trust trustee.

Day-to-day management of the OEIC funds is the responsibility of the director.

OEIC shares are single-priced – which means that the buying and selling prices are the same.

Initial charge – OEICs are usually subject to an initial charge, usually between 3–6%. However, the charge is taken directly from the investor’s capital rather than through an adjustment in the share price.

To give a simplified example, an investor invests £1,000 in an OEIC with a share price of £1 and an initial charge of 5%. He will actually receive 950 shares valued at £1 each, giving him a holding worth £950.

An OEIC is subject to a fund management charge – the fee paid for the services of the professional investment manager. The charge will vary but is typically in the region of 0.5% and 1.5% of fund value.

Dividends from an OEIC are taxable as non-savings income, depending on the source of the underlying income.

Gains made on disposal of an OEIC holding are subject to capital gains tax.

The advantages of unit trusts and OEICs are that:

• they offer a wide choice of funds and investment types;

• charges are generally lower than those of endowments;

• they offer the potential for capital growth over the medium to long term.

The disadvantages of unit trusts and OEICs are that:

• no guarantee is given that the fund will be sufficient to fully repay the mortgage at the end of the term;

• no life cover is included – this must be arranged separately, usually as level term assurance.

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 ISA 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:

ISAs are further divided into maxi- and mini-ISAs.

A maxi-ISA is one where all of the investment is under the control of one manager (the provider). The maximum investment is £7,000 each 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.

The main ISA rules are as follows.

An equity ISA carries a similar risk to that of an endowment policy.

The advantages of an ISA are that:

The disadvantages of an ISA are that:

A personal pension plan can be arranged by, or for, almost any person under the age of 75 who is resident in the UK. 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.

Pension simplification brought in a new set of rules from 6 April 2006. In summary, the rules are:

The advantages of a personal pension plan are:

The disadvantages of a personal pension plan are:

Mortgage interest can be calculated in one of three ways: on an annual basis; on a monthly basis; on a daily basis.

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 because 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 will be no better or worse off if he makes only one substantial mortgage payment shortly before the year-end. In fact, he might argue that he will actually benefit from such an arrangement because the money that would otherwise be used to make monthly payments can earn him interest in a savings account. The lender, of course, will 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 because 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 calculation of interest on a daily basis 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, while 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, encouraging borrowers to make additional payments whenever possible to reduce the term of their mortgage considerably.

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 is 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 has been an overall increase in the interest rate, resulting in more interest being charged to the account than has actually been paid by the borrower.

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

Lenders will 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 concept of the annual percentage rate (APR) 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

Section 2 describes the different mortgage interest rate options available; and explains the different mortgage products available.

Section 2 covers parts 2 and 3 of the syllabus for Unit 5.

The variety of mortgage products now on offer to the public is undoubtedly beneficial because it enables every prospective borrower to find at least one product that matches his needs – but the wide choice available also serves to confuse many people and it essential, in most cases, that a borrower seeks good quality advice.

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. The Bank of England base rate is reviewed by the Monetary Policy Committee of the Bank on a monthly basis.

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 must 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.

A fixed-rate mortgage does exactly what it says on the label; the rate of interest, and so the payment, is fixed for an agreed period, typically from one to five years, although even longer terms are becoming more common. The market for fixed-rate mortgages is highly competitive. Very attractive fixed rates are usually on offer to tempt borrowers to remortgage from their existing lenders – but how can lenders afford to offer these competitive fixed-rate products? There seems little or no profit to be gained, although a substantial number of new mortgage applications may well be received, 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 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. There are, however, other matters that need to be considered:

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.

The discounted rate 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: 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 things to consider when thinking about a discounted rate mortgage:

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.

The capped-rate mortgage is a variable rate mortgage that benefits the borrower in two ways:

Other factors to consider:

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: a mortgage with a 7% cap and a 3% collar will allow the rate to vary within those limits but, if rates were to go above 7%, the borrower would pay 7%, and if they were to drop below 3%, he would pay 3%.

A capped mortgage will be suitable for 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.

The base rate tracker mortgage. 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 BOEBR is reviewed and set by the Monetary Policy Committee every month.

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: 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. 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 that may apply to other variable rate borrowers.

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 recalculated 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 actually to define a flexible mortgage because it can be almost anything a particular lender wants it to be.

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

The lender would normally set parameters for underpayments and repayment holidays, although these can sometimes be renegotiated.

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. Typical lending limits will not usually exceed 75% LTV.

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; 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.

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. It is, however, 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.

The key points relating to a foreign currency mortgage are:

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.

As well as more generalist providers, the mortgage market is home to a number of specialist businesses that have made a niche in lending to, or arranging loans for, people who might not fit neatly into standard lending criteria.

The mortgages offered by sub-prime lenders reflect the risk taken and interest rates are usually higher than those applying to conventional mortgages. The borrower will also have a more limited range of options to choose from, although choice is improving.

As lenders develop more expertise in underwriting sub-prime mortgages, the products have evolved, to the extent that it is now possible to select from a range of products similar in structure to those in the general market. So, for example, it is now possible to arrange sub-prime mortgages on a variable, tracker, fixed, capped or discount basis. The essential difference lies in the rate charged and the underwriting process. It is even possible for borrowers with extreme credit problems to arrange a sub-prime mortgage – at a price.

The essential features that differentiate sub-prime mortgages from the mainstream are:

The self-certification mortgage is designed for those who have difficulty producing evidence of income. In principle, the applicant states their true income but the lender does not seek validation, allowing the mortgage to be underwritten on the basis of the income declared. This has led to some applicants exaggerating, or even falsifying, their income in an attempt to obtain a higher mortgage, working on the basis that low interest rates will cushion the impact of higher borrowing.

Many self-certification products have been withdrawn from the market following evidence of relatively large scale ‘cheating’, often encouraged by lenders and intermediaries, and the scandal that followed. It should be remembered that overstating income is fraud, even if the lender will not seek to verify the figures given. In general, the products available are similar to those in the general market, although arrangement fees and the interest rate charged will usually be higher. In many cases, the loan-to-value ratio before additional security is required, will also be lower.

Muslims wishing to buy property are faced with a religious dilemma because 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. 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: the Ijara method and the Murabaha mortgage.

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

With the Ijara (lease to own) method, the bank buys the client’s selected property. The bank then sells the property to the client for the same price under a promise to purchase agreement, with the repayment spread over a term of up to 25 years. The bank is the registered owner during the repayment term. The client occupies the property under a lease during the payment term, paying a monthly amount that combines capital repayment and rent for the lease. The monthly payment is fixed for 12 months at a time and is then reviewed to allow for adjustments to the rental element as appropriate; these adjustments will usually reflect changes in external interest rates.

Under Sharia law, the rent is seen as a fair price for using the property and so there is no conflict of principle. At the end of the payment term, the property is transferred to the client, although early repayment is possible during the term. The bank makes its profit from the rent paid over the term. In comparison with a conventional mortgage, the Ijara is more expensive – the monthly payments tend to be higher.

With a Murabaha mortgage 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 of around 20% of the property value, is required and then the client will then make 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.

From time to time, lenders offer other incentives to prospective borrowers and these may be added to any of the products previously described. 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.

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 he will also be able to take advantage of any reduction in the standard variable rate on the discounted rate element. 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, while 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 choose to apply this to the element that will incur the lowest early repayment charge.

Some potential homeowners feel that building a home to their own design and specifications is a better option than buying from a developer or on the general market. This option can result in significant cost savings when compared to the traditional route but can pose problems, in particular relating to finance, although the situation has improved over recent years. Self-builders can either build from traditional materials or use modern timber-framed technology, which is both flexible and speedy in comparison.

A number of lenders provide finance for such people, generically termed ‘self-build’ mortgages. The self-build mortgage allows the borrower to purchase the land and finance the building as well. Once the land has been purchased, the self-builder will need finance in stages, to pay for each phase of the building project.

Until relatively recently, lenders advanced finance as each phase was completed, usually limiting the lending to 75% of the land costs and 75% of the build costs. This left the self-builder with cash flow challenges as each phase was built, sometimes requiring expensive short-term borrowing to keep the work on track. Modern self-build mortgages are more flexible, and provide advance funding for each phase. Lenders vary in their attitude and approach to underwriting, but it is now possible to obtain self-build finance for up to 95% of the land costs, 95% of the cost of a timber-framed house kit and 95% of the build costs. In addition, most self-build lenders allow the borrower access to all or most of the normal products – variable, fixed and so on.

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 might result in a large sum being repaid. The fulfillment of this risk has led to the withdrawal of virtually all SAMs from the market.

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. This is in no way related to the fact that 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, but can be summarised as follows.

For all variable, fixed and capped rate mortgages, the standards relating to charges are:

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

Other charges criteria applicable only to fixed and capped rate loans 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 buy a share in the property with the remaining share held by the lender, a developer or another provider.

A number of different schemes have been introduced during the past 20 years but a typical scheme arranged in conjunction with a lender might involve the borrower paying the standard variable interest rate on 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.

Where the property is purchased in conjunction with a developer, a conventional mortgage is arranged on the purchaser’s share and the developer takes a second charge on the rest of the property, making him a part-owner.

Equity share appeals mainly to first-time buyers who may be borrowing at the maximum and who wish to keep their monthly payments to a minimum, or who may not be able to arrange a mortgage large enough to purchase in the conventional way.

There are drawbacks: 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 because the already limited equity will be further reduced when the lender takes its share.

As a result of concern over housing affordability for those unable to afford their own home, the government developed the Homebuy scheme, which started in April 2006. The target is to help 100,000 households to own their own property by 2010, 20,000 of whom will be helped through an agreement between the government and three major lenders announced in December 2005.

The scheme is targeted at three groups:

The Homebuy scheme is based on the principle of equity share and there are three types of Homebuy product.

The Social Homebuy scheme is available to those ‘social’ tenants who do not have the right to buy or who cannot afford to exercise their right to buy. To qualify, the applicant must be in rented accommodation provided by a registered social landlord or local authority, or on an official waiting list and nominated by the local authority as being in need. Those on a temporary tenancy do not qualify and the social landlord can decline an application if it feels the tenant could afford to buy without help. From the landlord’s perspective, the scheme is voluntary; it does not have to be offered to tenants.

Tenants will be able to buy a share in the equity of their local authority or housing association property, with a discount on the purchase price. In order to encourage landlords to participate, the government will meet the cost of the discount offered.

The tenant is able to purchase a minimum initial share of 25%, with the landlord holding the remaining equity. The landlord can charge up to 3% per annum of the retained equity. When the new owner sells the property, the landlord will be entitled to its share of the equity.

The New Build Homebuy scheme is designed to allow the buyer to acquire a minimum of 25% of the equity in a new property built with public subsidy. The remaining equity will be held by the provider, who is able to charge up to 3% of the remaining equity each year.

The first-time buyer initiative is a variant of the New Build scheme, through first-time buyers will be able to buy property built on land owned in the public sector at less than the full market price. 50% of these houses will be available to key public sector workers, with the remainder available to other first-time buyers identified as a priority for assistance by the regional housing boards.

The Open Market Homebuy scheme allows a buyer to purchase an equity share of up to 75% in a property sold on the open market. The balance of the purchase price will be covered by a loan from a housing provider on an equity share basis. The maximum loan for the equity share is £50,000; certain teachers in London, identified as future leaders, will be able to receive up to £100,000. From October 2006, a number of lenders will provide equity loans in a two-year pilot scheme; the loan will be split between the lender and the government.

In all of the above cases, buyers will be able to buy further portions of the property, with a minimum of 10% bought each time (based on the property value at the time), until they own the whole property: this is known as staircasing. In exceptional circumstances the buyer may be able to sell a portion back to the provider.

On selling the property, the owner will receive a share of the proceeds in proportion to the equity he owns: if the property is worth £150,000 and he owns 75%, the owner will receive £112,500 and the provider/landlord will keep £37,500. The provider may retain the right to buy back the property or to sell it to a prospective buyer from a waiting list. If this is not the case, the property can be sold on the open market. The new buyer will buy a share of the property, with the provider retaining the balance.

Any money received by a housing provider on resale of the property must be put back into the scheme to provide more housing.

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.

Typically, the individual will purchase a 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 bought 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 eventually allow the property to be purchased outright, while others may impose a limit of 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, because it is important that the borrower is not overstretched financially. There will usually be some form of higher 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 even 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.

The basic rules for existing tenants are:

The rules for new tenants are that:

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.

Where the right to buy was exercised before 18 January 2005:

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

If the right to buy was exercised on, or after, 18 January 2005:

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

Additionally, 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, while 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 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 that can 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; 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, however, 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 because 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 properties are now remaining empty for longer periods. The situation will be made worse if property prices start 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.

The FSA has established a special mortgage category, known as lifetime mortgages, that it defines as mortgages where:

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.

The term home income plan (HIP) is a misnomer: such a plan does not have to provide income at all. With a home income plan, the homeowner takes out a lifetime mortgage on their home. The lender will restrict the lending, usually to between 25% and 55% of the property value, depending on the borrower’s age. Because the property is being remortgaged, the loan is covered by mortgage regulations.

The capital released in this way can be used to provide an annuity or it can be invested in an income-producing vehicle, or it can be used 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 to provide a guaranteed level of income for life. 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 or, in many cases, non-existent. (Those who entered a HIP on or before 8 March 1999 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 but instead encouraged the borrower to buy an investment bond with the capital raised, using the growth on the bond to provide an income. Unfortunately, further problems occurred:

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. A number of court cases resulted in some lenders paying compensation to borrowers for selling an unsuitable product.

On the vast majority of modern HIPs, the borrower makes no interest payments 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 when the borrower decides to move. A 60-year-old borrower is likely to accumulate considerably more unpaid interest over the rest of his life than a 70-year-old and the younger one will not be able to borrow such a high percentage of the value of his property as his senior.

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.

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 wishes 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 because 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: 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 – but the problems only surface if they decide to move or when they die:

For these reasons, it is important that the homeowners and their families know exactly what they are doing and exactly what the scheme involves. 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.

Those intending to give advice on lifetime mortgages should be suitably qualified.

Section 3

Other mortgage-related products

Section 3 describes the products available to protect a mortgage in the event of death or incapacity.

Section 3 covers part 4 of the syllabus for Unit 5.

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. Combined policies have become much more common in the past 15 years or so.

Many buildings insurance policies are now 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 underinsurance are therefore considerably reduced.

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, eg £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 underinsured. 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:

Underinsurance is not as 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 underinsured 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 underinsurance.

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 copies for both the lender and insurer.

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 must 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 that 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.

Even under these circumstances, 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 will 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 the receipt of lower levels of commission 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 it agrees to the borrower arranging 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 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 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 in cases of lapse in the payment of premiums or a submission of a claim. The lender will be reassured that the freeholder is 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. Standard procedures 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 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, so 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 repay the outstanding debt in full, 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 will be repaid in full on death. 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 level term assurance, 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 will be a surplus available after the mortgage has been repaid that will benefit the surviving borrower.

Level term assurance is incorporated in a unit-linked endowment policy and guarantees to repay in full 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 because neither of these products have any built-in life cover.

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 also 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 now relatively rare, 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 single-life 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, and can offer a tax-efficient way of protecting a mortgage. From 6 April 2006 the amount of PPTA that can be purchased is not subject to strict limits as before.

There are three factors to consider:

A mortgage payment protection insurance (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 consequently sometimes called accident, sickness and unemployment insurance, although this is not a particularly accurate description because 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:

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 permanent health insurance (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 because 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: 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 replace lost earned income in full because 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, 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 occasions 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 will be applied if the policyholder were forced to give up full-time employment for part-time employment. These benefits are only available, however, if the policy has been written on an any occupation basis.

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

Some occupations carry a greater risk than others: an office worker will 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. 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, 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 and this is particularly beneficial to those who may have difficulty arranging their own policy because of poor health.

It is usually the case, however, 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 but it can only be paid once, after which the policy is cancelled.

Critical illness insurance can be either a stand-alone policy or 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 repay in full 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 paid, 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.

Not all lenders take out mortgage indemnity insurance (MIG). Where they do, the threshold varies between lenders 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 will be unlikely to be able to borrow 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 explained and described to applicants as a higher lending charge, not simply as a MIG premium.