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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 may change either of them. In the past the endowment policy was often taken as additional security by the lender, for instance by ensuring that the proceeds of the endowment were made payable to them rather than the borrower. This practice is uncommon now.

Advantages of 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 aim is that the endowment policy will be sufficient on maturing to repay the mortgage at the end of the term, possibly even with a cash surplus.

Up to 1984 qualifying insurance contracts (including endowment policies) received tax relief known as LAPR (Life Assurance Premium Relief) on the premiums. Similarly MIRAS (Mortgage Interest Relief At Source) made having an endowment mortgage relatively advantageous as the decrease over time of interest repayments on a repayment mortgage meant decreasing MIRAS relief. These tax incentives in favour of endowment mortgages are not often commented on in the media.

Problems with endowment mortgages

The underlying premise with endowment mortgages is that the rate of growth of the investment will exceed the rate of interest charged on the loan. Towards the end of the 1980s, when endowment mortgage selling was at its peak, the projected growth rate for endowment policies was high (7-12% per annum). By the mid-1990s, lower inflation rates made these projections look optimistic.

Regulation of investment advice and a growing awareness of the potential for regulatory action against the insurers led to a reduction in projected growth rates down to 7.5% and eventually as low as 4% per annum. By 2001 the arrangment of new endowment mortgages had virtually ceased.

Shortfalls

Financial regulations introduced compulsory reprojection letters to show existing endowment holders what the likely value of their endowment would be on maturing, assuming standard growth rates. Many endowment holders have complained of mis-selling, which in turn has spawned a secondary trade in “handling” complaints on consumers’ behalf for a fee (even though the consumers can pursue it themselves at no charge).

In many cases the regulators have found in favour of the policyholder and have required the insurer or broker responsible for the original advice 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.

The big advantage of a repayment mortgage is that at the end of the mortgage term, the debt is repaid in full. It also removes the risk involved in an endowment mortgage, where ability to repay ultimately depends on performance of the endowment policy in the stockmarket. The borrower is also less likely to suffer from negative equity because the mortgage balance will be reducing month on month.

As time progresses, the equity percentage in the property increases. However, in the early years the bulk of the mortgage repayments go towards paying off the interest component, so not much of the capital is actually paid off for some time.

To protect the lender, a mortgage by legal charge is usually recorded in a public register. Since mortgage debt is often the largest debt owed by the debtor, mortgage lenders run title searches of the real property to ensure that there are no mortgages already registered on the property which might have higher priority. Tax liens, in some cases, come ahead of mortgages. For this reason, if a borrower owes property tax arrears, the mortgage lender may pay them to forestall a foreclosure by the lienholder which would wipe out the mortgage.

This type of mortgage has been the usual form of mortgage in England and Wales since 1925 and, under the Land Registration Act 2002, is now the only form permitted by law.

The mortgage by legal charge is also known as standard security in Scotland.

Mortgage by demise

In a mortgage by demise, the creditor owns the mortgaged property until the loan is repaid in full (“redeemed”). This kind of mortgage takes the form of a conveyance of the property to the creditor, with a condition that the property will be returned on redemption.

This older form of legal mortgage has been less common than a mortgage by legal charge in recent years and under the Land Registration Act 2002 is no longer available in the UK.

Often the purpose of switching is to secure a more favourable interest rate from a different lender. Borrowers may ask for a quote from several lenders to remortgage the property at various times during the term of the original mortgage, and may or may not remortgage depending how favourable the quotes are. Many lenders include penalty clauses in the original mortgage agreement precisely to deter borrowers seeking quotes for remortgages.

Remortgaging does not usually involve moving home or taking out a second mortgage on the property; effectively the mortgage is transferred from one lender to another, or from one product to another with the same lender.

There are several reasons why homeowners may choose to remortgage, including to reduce the size of repayments, to pay off a mortgage more quickly, to raise capital, or to consolidate the mortgage with other debts.