Saturday, 16 July 2011

Did endowment mortgages deserve to die in disgrace?

This morning, I was looking through some documents and came across some papers relating to my mortgage.

I have an endowment backed mortgage which is an interest-only loan backed by an endowment policy. Buying an endowment mortgage turned out to be a big mistake, but at the time, I knew no better.

I know for a fact my endowment will not cover the mortgage when the mortgage becomes due in a few years time. Luckily, I have known this for a while and, years ago, switched a good chunk of the mortgage from interest-only to repayment. It won't matter if there is a shortfall.

A mortgage is a long term loan secured against your house.

There are essentially two ways of repaying your loan:

1) repayment - each month you pay the mortgage provider (usually a bank or building society) an amount. That amount goes to pay off the interest on your loan and pay down some of the capital borrowed. In the early days, all, or much of, the monthly amount goes towards paying back the interest on your loan. Later on, much of your monthly payment goes towards reducing the capital you owe. At the end of the mortgage term, the homeowner won't owe the mortgage provider anything.

2) Interest only - this means that you pay off only the interest on your loan but none of the capital (amount borrowed). At the end of your mortgage term, you still owe the mortgage provider the whole amount you borrowed. You have to pay the bank/ mortgage provider the full amount you borrowed.

Some people have used their savings and investments to pay off their mortgages. Other more optimistic souls have been known to plan to use inheritances and lottery wins to pay back the borrowed capital. The point is that the mortgage providers really doesn't care where the money comes from, only that it comes and comes back in full.

This is where endowment policies neatly filled a yawning gap in the market. The idea was along the lines of, 'if you borrowed £XX,000 to buy your house. Every month, you would:

(1) pay the mortgage provider £YYY to cover the interest on your loan of £XX,000.

(2) pay the endowment provider £ZZ. This would be called your endowment policy.'

This monthly payment of £ZZ will go towards:

  •  providing you with enough life insurance to pay back your loan of £XX,000 should you meet your maker before your mortgage term ended. 
  • building a savings fund. Come the end of you mortgage, you will have a nice wodge of savings: enough to pay off your loan of £XX,000 and some left over to go on a round the world cruise/ buy the husband a new set of golf clubs/ keep your wife in handbags/ bank roll your kids/ (insert your own indulgence here) 

People who had bought endowment mortgages that expired in the 1980s and mid 1990s were generally pleased with results: they were able to pay off the mortgage provider and trousered the excess as a nice little lump sum, to spend as they saw fit.

Stories abounded of Mr and Mrs Man-on-the-Street who had pocketed a tidy sum after paying off their mortgages and this made it very easy for salesmen to sell endowment backed mortgages on the strength of past performance. I doubt much persuading had to be done.

Unfortunately, people who had endowment backed mortgages that expired later than the mid 90s and people who currently have endowment backed mortgages that are yet to expire found/ find themselves in a position where they may not get a lovely lump sum and significantly worse, aren't going to get to enough to pay back the original £XX,000 loan. They will have to find the money elsewehere.

In my opinion, endowment backed mortgages got a lot of bad press. There is nothing wrong with them per se although there is definitely a time and place for them. They seem to work best during long periods of:

(1) high inflation
(2) strong stockmarkets

In the last ten years, inflation has been kept relatively low (low to mid single digit figures) and the stockmarket has generally moved sideways, though punctuated by periods of volatility.

Endowment back policies would not work well in the prevailing UK economic climate but that is not to say that they are a bad thing or that they wouldn't work in other countries now or even in the UK at a different time.

For the moment, endowment backed mortgages have been consigned to the great investment rubbish bin in the sky - and rightly so, given current economic conditions.

However, I have no doubt that they will appear again at some point, though probably with a shiny new name.