- Endowment mortgage
An endowment mortgage is a
mortgage loanarranged on an interest-only basis where the capital is intended to be repaid by one or more (usually Low-Cost) endowment policies. The phrase endowment mortgage is used mainly in the United Kingdomby lenders and consumers to refer to this arrangement and is not a legalterm.
The borrower has two separate agreements. One with the lender for the mortgage and one with the insurer for the endowment policy. The arrangements are distinct and the borrower can change either arrangement if they wish. In the past the endowment policy was often taken as additional security by lender. That is, the lender applied a
legaldevice to ensure the proceeds of the endowment were made payable to them rather than the borrower; typically the policy is assigned to the lender. This practice is uncommon now.
Reasons for an endowment mortgage
The customer pays only the interest on the capital borrowed, thus saving money with respect to an ordinary repayment loan; the borrower instead makes payments to an endowment policy. The objective is that the investment made through the endowment policy will be sufficient to repay the mortgage at the end of the term and possibly create a cash surplus.
Up to 1984 qualifying insurance contracts (including endowment policies) received tax relief on the premiums known as
LAPR(Life Assurance Premium Relief). This gave a tax advantage for endowment mortgages over repayment. Similarly MIRAS (Mortgage Interest Relief At Source) made having a larger mortgage advantageous as the MIRAS relief reduced as a repayment mortgage was repaid. This tax incentivisationtoward endowment mortgages is not often commented on in the media when they discuss endowment mortgages.
An additional reason in favour of an endowment was that many lenders charge interest on an annual basis. This meant that any capital repaid on a monthly basis is not removed from the outstanding loan until the end of the year thus increasing the real rate of interest charged. In such a situation, payments into an endowment might benefit from any growth from the moment it is invested. Henceforth, the net investment return required for the endowment to pay the loan, would be less than the average mortgage interest rate over the same period.
Traded endowment policies
Traded endowment policies (TEPs) or second hand endowment policies (SHEPs) are traditional with-profits endowments that have been sold to a new owner part way through their term. The TEP market enables buyers (investors) to buy unwanted endowment policies for more than the surrender value offered by the insurance company. Investors will pay more than the surrender value because the policy has greater value if it is kept in force than if it is terminated early. In the UK, this trade is partially governed by a trade body, The Association of Policy Market Makers.When a policy is sold, all beneficial rights on the policy are transferred to the new owner. The new owner takes on responsibility for future premium payments and collects the maturity value when the policy matures or the death benefit when the original life assured dies. Policyholders who sell their policies, no longer benefit from the life cover and should consider whether to take out alternative cover.The TEP market deals exclusively with Traditional With Profits policies. The easiest way of determining whether an endowment policy is in this category is to check to see whether an it mentions units, indicating it is a Unitised With Profits or Unit Linked policy, if bonuses are in sterling and there is no mention of units then it is probably a traditional With Profits. The other types of policies - “Unit Linked” and “Unitised With Profits” have a performance factor which is dependent directly on current investment market conditions. These are not tradable as the guarantees on the policy are much lower and there is no gap between the surrender value and the market value.
Problems with endowment mortgages
The underlying premise with endowment policies being used to repay a mortgage, is that the rate of growth of the investment will exceed the rate of interest charged on the loan. Toward the end of the 1980s when endowment mortgage selling was at its peak, the anticipated growth rate for endowments policies was high (7-12% per annum). By the middle of the 1990s the change in the economy toward lower inflation made the assumptions of a few years ago look optimistic.
Regulation of investment advice and a growing awareness of the potential for regulatory action against the insurers lead to reduction in anticipated growth rates down to 7.5% and eventually as low as 4% per annum. By 2001 the sale of endowments to repay a mortgage was virtually seen as taboo.
Financial regulations introduced compulsory "re-projection letters" to show existing endowment holders what the likely maturity value of their endowment would be assuming standard growth rates.
This in turn lead to a dramatic rise in complaints of mis-selling and spawned a secondary industry that 'handles' complaints for consumers for a fee, even though they can pursue it themselves for free.
In many cases, because risk warnings were not made clearly lie they are in today's investment market, the insurer or broker responsible for the original advice have found in favour of the policyholder and have been required to restore their customers to the financial position they would have been in had they taken out a repayment mortgage instead. As of July 2006, UK banks and insurance providers have paid out approximately £2.2 billion in compensation. [ [http://icwales.icnetwork.co.uk/0300business/0100news/tm_objectid=17475172&method=full&siteid=50082&headline=endowment-mortgage-claims-double-to-more-than--pound-2bn-in-a-year-name_page.html icWales] ]
* [http://www.financial-ombudsman.org.uk/faq/mortgage.htm Information from the Financial Ombudsman Service]
* [http://www.fsa.gov.uk/consumer/01_WARNINGS/endowments/mn_endowment.html FSA Endowment Mortgage Complaints]
Wikimedia Foundation. 2010.