Once, UK endowment mortgages were one of the most popular investment vehicles for home buyers.
But popularity in the 1980s/1990s has been replaced by controversy, amid fears of shortfalls and accusations of mis-selling.
However, let's leave all that aside as we look at the 'nuts and bolts' of the endowment mortgage.
Again, there are two distinct parts to the endowment mortgage, with monthly repayments split between interest, paid to the lender, and premiums, paid towards the 'investment vehicle', the endowment assurance offered by the life assurance company.
The endowment assurance combines life insurance and investment, paying out the sum assured either at the end of the term, or on the death of the life assured, if this occurs before the end of the term.
The premiums paid monthly are invested by the assurance company in the stock market, the aim being the returns realised at the end of the term will be sufficient to pay off the mortgage loan capital.
Such an investment vehicle is attractive to the lender because life policies can be legally assigned to a third party, who then becomes entitled to receive the benefits.
Endowments can be non-profit, with-profit, unit-linked or unitised with-profit.
Non-profit guarantees a fixed return on maturity of the policy (i.e. at the end of the term). But as a consequence of being 'shielded' from the ups-and-downs of the stock market, there is no share of any profits that may accrue.
With-profits, on the other hand, allows the policyholder to share in the profits through annual bonuses (which once added, cannot be taken away) and a terminal bonus at the end of the term. However, premiums are usually higher.
Monthly payments (premiums) in a unit-linked endowment are used to purchase further units in a chosen investment fund. The number of units builds up over time and, at maturity of the policy, the policyholder receives a sum equal to the total value of all of the units.
Similarly, with the unitised with-profit endowment, premiums are used to purchase units. But, in addition, bonuses are added, usually on a yearly basis. Because these cannot be taken away, the price of the units cannot fall and therefore the value of the policy on maturity is guaranteed.
Now, as far as the endowment mortgage is concerned, it can be seen from the above that borrowers are far more likely to go for the with-profit endowment because it offers a far higher return. The downside is that it costs more, which becomes a real concern for the borrower trying to keep mortgage costs to a minimum.
Enter the low-cost endowment, a with-profit compromise, based on an assured sum lower than the mortgage loan (therefore cheaper premiums) but which should still pay off the capital because of the expected bonuses (terminal bonus not included) to be added regularly over the term.
However, if the sum assured and bonuses fall short of the capital amount required, the borrower will have to find the difference.
On the other hand, if the return is greater than expected, not only will the mortgage loan be paid off completely, but the borrower will receive the surplus as a tax-free lump-sum.
One of the attractions of a unit-linked endowment as an investment vehicle is the prospect of early repayment of the mortgage loan.
Another is that policyholders can choose which fund(s) to invest in, although a managed fund is highly desireable in order to minimize risk - remember, we're talking mortgage here!
The monthly premium is used to purchase units, and is calculated on the basis of the expected (conservative) rate of growth of the units sufficient to return enough to pay off the loan capital at the end of the term.
However, rising market conditions may push up the value of units more quickly than expected. The value of the policy reaches the required amount ahead of schedule and thus can be surrendered earlier, enabling the loan to be paid off and future interest payments saved.
Of course, the opposite may happen. The growth rate falls below expectations and premiums may have to rise to compensate.
And because of such uncertainties, often there is provision towards the end of the term to switch to some kind of cash fund to protect the value of the policy.
However, if any shortfall does arise at the end of the term, it is the borrower's responsibility. But, reputable companies usually build in a review process throughout the term in order to avoid such problems.
