Endowment Mortgages - what are they?

When you take out a loan to buy a house, you can repay it in various ways.

One way is to invest in an endowment life policy. You cover the interest on the loan, and you also pay premiums on the life policy. The insurance company invests most of the premiums for you. The idea is that, when the policy "matures", it will pay out at least enough money to repay your mortgage loan.

You get a bonus every year which can't be taken away, and then a terminal bonus when the policy matures at the end of its agreed term (say, 25 years). This terminal bonus can amount to half of all the gains from the policy.

A former senior industry insider says

Existing with-profits investors have no idea what is happening with their money. Managers may do things against their best interests but investors would never know.

Most of the premiums? What happens to the rest?

The premiums also provide life cover. So if you die before the mortgage is repaid, the loan will be repaid from the insurance policy at once.

Whoever sold you the policy also gets commission. This comes out of your premiums. Often a lot of the premiums in the early years are used to pay commission.

On a 25-year endowment the first 12 to 18 months' savings may go on commission and charges rather than being invested for your benefit.

Annual management charges can be up to 2.5% a year.

Hm, so is an endowment mortgage a bad idea?

In principle it's fine.

There used to be tax relief on these premiums. And on the mortgage interest (MIRAS). That helped. And in times of high inflation the value of the policies tended to grow fast. Obviously the mortgage didn't rise with inflation.

These factors made endowment policies a good way to repay a mortgage.

But not any more?

Mortgage interest relief has ended and tax relief on the premiums has been abolished.

And the value of the policies goes up more slowly when interest rates and inflation are low, as they have been recently. Some people are now being told they will have to increase their payments in order to ensure that the mortgage loan can be repaid when the life policy matures. Often the premiums have to go up a lot.

This can make endowment policies look less good value than a repayment mortgage.

With a repayment mortgage, the repayments go directly to the loan itself. So as time goes on, the loan gets gradually less and less. This means less interest to pay too. Repayment mortgages also mean less commission for a salesman.

Some people say people were wrongly advised to take an endowment mortgage because of the commission the salesman could get, when a repayment mortgage would have been more suitable for them.

The Personal Finance Authority ombudsman says many savers may be entitled to compensation from banks, building societies and insurance companies if they were sold endowments without being warned that they might not pay off the mortgage. More here.

How popular are endowments?

In 1988, 83% mortgages sold were endowments. By 1998 it was 34%. But still in 2000, 13% of first time buyers choose an endowment mortgage.

Probably this is far too many.

By now, most large lenders have stopped selling endowment mortgages. Usually they say this is because they are not selling enough to justify all the training, compliance and monitoring necessary. But Lloyds TSB said it decided to stop sales because of the continuing trend towards low interest rates, and the withdrawal of mortgage interest tax relief, which made endowments a poorer investment.

According to the FSA, by September 2000 only 20 insurance companies were still selling endowment policies for mortgages.

I'm taking out a new mortgage. Is an endowment mortgage a good idea?

If you haven't got one already, possibly not.

It may suit a high rate tax payer who has uses up their ISA allowances in other ways - the maturity payout is not subject to capital gains tax because it is an insurance contract. So it can be a good way to benefit from equity growth, though at a lower rate than direct equity investment.

Sir Howard Davies comments [my comment in brackets]:

The with profits policy allows investors an easy way to share in stock market growth, with returns smoothed over time - a valuable benefit for those whose policy terminates during a bear market. [But there are other ways to achieve this safeguard.]

Against, is evidence that the smoothing achieves little over and above what can be achieved by investing in an index fund, partly because the funds are rarely invested entirely in shares, while the overall costs are higher.

Furthermore, returns close to what might have been achieved simply by investing in a balanced portfolio of shares are achieved only by those investors who stay the course over 25 years, largely coming in the form of a terminal bonus. For various reasons, many surrender early and lose out as a result.

Consult an Independent Financial Adviser.

They say my policy won't repay my endowment mortgage

There is more about endowment mortgage shortfalls here.