When taking out a mortgage, most people simply use the repayment route - as the life of the mortgage goes on you repay a larger and larger chunk of the capital value of your home. In the first few years most of the repayment is interest, but, as the years go on, you quickly eat into the capital. However, there is also an option to simply repay the mortgage interest and only at the end of the term of the mortgage to repay the capital. This was fairly popular in the 1980s and early 1990s, when rates were high. By not repaying capital, monthly repayments were kept down. And to repay the capital people took out endowment mortgages. These are basically savings plans with insurance companies.
The extra say, £50, a month which would go towards repaying capital would be put into a fund; the theory was that it would grow more quickly than the return on simply paying off the mortgage. These funds got a lot of bad publicity when people began to fear that a stock market crash, or a very poorly run fund, could mean people would not have enough money to repay their mortgage at the end of the term, never mind have a large lump sum left over for a cruise. Another way to fund the eventual repayment is to use your pension. This is an extremely tax efficient way of repaying your mortgage that works in a very similar way to the endowment mortgage - but there are pitfalls. You pay only the interest on the loan and do not make any capital repayments. Instead, you use that money to increase the funding of your pension. Pensions payments are tax free, so that is a big boost.
Only people with a personal pension can use this option and it is not available to those with occupational schemes unless they are controlling directors.
The big danger is, of course, that the bulk of your pension goes towards repaying the mortgage, leaving you with far less to live on in retirement. As a result, according to Mr Donal Brady, general manager in Ireland of Equitable Life, this is probably only suitable for those with substantial other assets for their retirement.
"This is very attractive from a taxation point of view, but if you use part of your fund to repay your mortgage, you then have to make up that portion elsewhere." One argument is that the property itself will make up the shortfall, particularly if the rental income is high. However, you must remember that there are additional expenses and taxation and so on.
It is also important to remember that you cannot draw down your pension until you are 60, so you cannot pay off your mortgage until this time.
As a result, it is really only suitable for those between the ages of 40 and 50. While the money grows tax free in the pension, you do have to pay income tax and capital gains tax once you actually take the cash at retirement.
Under the old rules, you could take 25 per cent of your pension fund as a lump sum on retirement: it was this that was used to repay the loan. As a result you would need to have a fund of £400,000 to repay a loan of £100,000. But this has changed under new rules introduced by Minister for Finance, Mr McCreevy, in the recent Finance Bill.
It is now possible to take the 25 per cent tax free and pay tax on the remaining 75 per cent. As a result, that £400,000 fund would be able to pay off a mortgage of around £280,000. Many lenders are fairly cautious about lending for a pension mortgage and generally loans are 80 per cent maximum. This is because they cannot attach a pension scheme as security. However, most lenders will consider the route if you put up a convincing case .
One of the other ways of buying property in a very tax efficient manner is to use a small self-administered pension scheme. The rules for these are very complicated and anyone interested should contact a pensioner trustee. But basically they allow someone to buy property and put it into their own pensions fund. If certain criteria are met the rental income is tax free and can be used for the fund.
The Ebs now calculates its mortgage repayments on a monthly rather than annual basis.
