D5.05: SUITABILITY OF REPAYMENT AND PROTECTION METHODS

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1 D5.05: SUITABILITY OF REPAYMENT AND PROTECTION METHODS SYLLABUS Suitability of mortgage repayment methods to consumer circumstances Suitability of mortgage protection methods to consumer circumstances Comparisons between methods Suitability and comparisons The notes below are based on those for D5.01 Repayment mortgages, D5.02 Interest only mortgage repayment, D5.03 Life assurance linked to mortgages, and D5.04 Other protection linked to mortgages, and cover the necessary suitability and comparative points Repayment mortgages Generally, monthly repayments under a repayment mortgage (more fully known as a capital and interest repayment mortgage) are designed to stay constant through the term (assuming interest rates do not change) Repayment mortgages are also sometimes referred to as annuity mortgages Initially, almost all of the monthly amount paid by the borrower consists of interest, but there will be a small amount of capital repaid As an illustration, after ten years of a 25 year repayment loan, only around 25% of the borrowing will have been repaid assuming a 5% pa interest rate The gradual reduction in capital outstanding results in a reduction in the interest due, so as the term progresses, the amount of capital repaid each month gradually increases The major advantage of a repayment mortgage is that the loan is certain to be exactly repaid by the end of the term, provided that repayments are kept up This includes keeping up revised payments if interest rates change during the term There is no investment risk as would apply in using an investment product to build up capital to repay at the end of the term, where growth needs to be at least in line with assumptions in order to avoid a shortfall On the other hand, there is no opportunity to build up an excess over the amount required to repay These loans therefore often appeal to, and are suitable for, risk averse borrowers For those who feel their circumstances may change and that they may move in the next few years, the repayment mortgage often offers most flexibility This is because there is no commitment to a particular investment product for repayment, and the loan reduces slightly even over the first few years Interest only mortgages Interest only mortgages require the borrower to make interest payments only to the lender each month The loan must be repaid by the end of the term, and this can be done by means of a single repayment Generally borrowers save for repayment through an investment product

2 The lender may require details, or sometimes assignment (where possible) of the product However, increasingly, lenders do not insist on this, but rely on the borrower arranging an appropriate investment product The most common types of investment product used are endowments, ISAs and PPs (Personal Pensions) It is possibly to repay the mortgage early, either wholly or partly, if monies are available from the chosen product For example, if the investment product performs well, early repayment may be possible, but penalties may apply under the investment product (particularly with endowments) PPs are restricted in terms of access by pensions legislation, and currently benefits cannot usually be accessed before age 55 (50 prior to 6 April 2010) In some cases, there may also be an early repayment charge under the terms of the mortgage if repayment is made before the end of the mortgage term Endowment mortgages An endowment policy is a convenient repayment vehicle, because life cover as well as investment is included However, it is often not the most tax efficient approach available, because the underlying investment fund pays tax on both income and capital gains Generally, a mortgage-related endowment is a qualifying policy, so there would be no personal tax to pay on the maturity proceeds, but the policy term must be at least ten years Early surrender can create a higher rate income tax charge if premiums have not been paid for at least ten years, or, if less, three quarters of the term Endowments are also relatively inflexible, and require regular premiums throughout the term The term is fixed and the level of premiums is generally also fixed throughout the term At one time, some tax relief (Life Assurance Premium Relief or LAPR) was available on endowment premiums, which improved the position, but this no longer applies to new policies With an endowment policy (whether with profit or unit-linked), waiver of premium can also be added (subject to this being available from the chosen product provider) Most endowment mortgages are based on low cost endowments or unit linked endowments A full with profits policy is a low-risk alternative but is relatively expensive It has a guaranteed sum assured (GSA) equal to the amount of the loan, and so guarantees that the policy proceeds at maturity (or earlier death) will be sufficient to repay the mortgage Low cost policies A low cost endowment is in effect a combination of a with profit endowment assurance with decreasing term assurance, packaged within one policy The GSA starts off below the amount of the loan, and is designed to build up to at least the loan amount through the addition of bonuses There is no guarantee that bonuses will be sufficient to do so however and future bonus rates are not guaranteed As with a full with profits endowment, bonuses which have been added cannot subsequently be removed or reduced however The sum assured on death during the term is guaranteed to at least equal the amount borrowed (this is where the decreasing term assurance comes in)

3 The death benefit is the greater of the guaranteed amount (equal to the amount borrowed) or the GSA plus bonuses Thus, if bonuses are good, the death benefit will increase towards the end of the term The advantage of a low cost policy is that the premium is considerably lower than for a full endowment The disadvantage is that the proceeds at maturity are not guaranteed to be sufficient to match the amount borrowed A low start low cost endowment is a variation of the low cost endowment, but with premiums starting low and increasing at a set rate, usually over the first five years of the policy, after which they remain fixed This may appeal to a first time buyer who is particularly stretched financially at the start of the mortgage, though care is needed to ensure the borrower does not over-reach Unit-linked policies A unit linked endowment can be used for mortgage repayment and depends on growth to achieve a sufficient maturity value There is no guarantee that the proceeds at maturity will be sufficient to repay the amount borrowed There is generally no guarantee of any minimum maturity value Premiums (after charges) buy units in one or more unit-linked fund(s) and the proceeds at maturity will be the value of the units held under the policy The death benefit under a unit-linked mortgage endowment is the greater of the sum assured and the value of units built up to the date of death The sum assured is equal to the amount borrowed so the policy is guaranteed to be sufficient to repay this amount on death Extent of guarantees Endowment policies are guaranteed to produce at least the sum assured on death Assuming this is equal to the amount borrowed, the proceeds are therefore guaranteed to be sufficient to repay this on death The full endowment has a maturity guaranteed sum assured equal to the amount borrowed, and so the maturity proceeds are guaranteed to be sufficient to repay this This is therefore a low risk (but expensive) approach The maturity proceeds under low cost policies and unit-linked policies are dependent on growth and are not guaranteed to be sufficient Under with profits policies, reversionary bonuses are declared (usually annually) and once added to the policy cannot be reduced or reversed (though they will not apply in full if the policy is encashed early) Similarly, growth on with profits unitised policies cannot be removed (though a Market Value Reduction can apply on early encashment) However, bonus rates are not guaranteed in advance Terminal bonus may attach at maturity, but is not guaranteed in advance, and so could be zero The progress of endowments or indeed other repayment vehicles should therefore be monitored and if growth is lower than expected, it may be necessary to increase premiums or make other repayment arrangements

4 ISA mortgages An ISA (Individual Savings Account) is a tax efficient means of repayment, but cannot be assigned The value at the end of the mortgage term is dependent on growth (the ISA itself does not have a fixed term) ISAs are very flexible and (within limits) contributions can be regular or can be occasional lump sum amounts (or a mix of the two) ISAs are generally regarded as carrying a relative high level of risk because investment is usually largely in equities It is possible to withdraw money from the ISA, or encash it entirely, during the mortgage term with no loss of tax advantages This increases flexibility, but if money is withdrawn for purposes other than repaying the mortgage, this is likely to mean having to invest more later to stay on track to repay the loan There is generally no guarantee of the value which will be achieved within the ISA at maturity Life cover should be arranged separately, and would need to be on a level rather than decreasing basis This reflects the fact that the loan remains constant, and the value building up within the ISA may fluctuate ISA tax treatment and limits There is no special treatment for an ISA used to repay a mortgage, so all the normal ISA rules apply There is no minimum or maximum term for an ISA, so the ISA can be cashed in at any time Contributions can be regular, or can be paid by irregular lump sums (or a combination of the two) Even if contributions are initially intended to be regular, this can be changed later if the borrower so wishes Contributions can therefore stop and restart later with no restriction or tax disadvantage However, the borrower should monitor how this affects the expected value at the end of the loan term The minimum age to start an ISA is generally 18 (16 for the cash component only) The fund growth is free of tax on income and gains, except that dividend tax credits cannot be reclaimed There is no tax liability on withdrawals or full encashment and no loss of the tax advantages enjoyed while the ISA was in force An ISA cannot be assigned to a lender The maximum total annual contribution to ISAs in 2010/11 is 10,200 Of the maximum, anything from zero to 5,100 can be invested in a cash ISA, with the rest in a stocks & shares ISA No tax relief is available on ISA contributions however

5 PP mortgages A personal pension (PP) is also very tax efficient, because tax relief is available on contributions in the normal way Contributions can be regular or one-off, although regular contributions are most usual where the PP is intended to provide for mortgage repayment Regular contributions can be increased, reduced, stopped or restarted at will All the usual rules, including eligibility conditions, contribution allowances and benefit rules apply in the same way to mortgage related PPs as to any other PP Assignment to the lender is not permitted Also, like ISAs, the fund growth is free of tax on income and gains, except that dividend tax credits cannot be reclaimed However only the cash benefit (25% of the fund) is available to be used for loan repayment when benefits are taken The monthly outlay for a pension mortgage is therefore likely to be relatively high, though a pension benefit is being accumulated as well The cash benefit (known as a pension commencement lump sum) is free of tax under current law Also, Personal Pensions cannot be usually accessed before age 55 (50 prior to 6 April 2010) Penalties may apply if a Personal Pension is accessed earlier than expected Other types of pension arrangement can be used for loan repayment, but are less common, and fewer lenders will accept them Life cover should be arranged separately Life policies can be written under PP legislation, and tax relief has been available in the past, but is no longer available on new policies As a result, new policies of this type are no longer generally available Life policies written under PP legislation can be assigned Life policy types suitable for mortgage protection Life cover is advisable alongside any mortgage, though it is not always required by lenders Endowment mortgages build this in as part of the endowment policy As a result, comparisons with other mortgage repayment methods should allow for the need to arrange life cover separately with those other methods A decreasing term assurance policy is suitable alongside a repayment mortgage because the outstanding loan reduces during the term of the mortgage A mortgage protection policy is a decreasing term policy specifically designed to cover mortgage borrowing on this basis This should not be confused with mortgage payment protection insurance, which provides for continuation of mortgage repayments if the borrower suffers incapacity or compulsory redundancy (mortgage payment protection insurance is outside this syllabus area) The cover under a mortgage protection policy reduces in broadly the same manner as the outstanding loan reduces on a repayment basis

6 Level term is usually preferred alongside other mortgages such as ISA or pension mortgages, because the build up of any repayment vehicle is not predictable and the outstanding loan amount does not reduce For joint mortgages, the policy is usually arranged on a joint life first death basis and therefore pays out the full sum assured when either of the joint borrowers dies If the cover on the survivor is required to continue, separate policies should be established on each borrower, with sums assured equal to the amount borrowed A whole of life policy could be used to protect a mortgage, but is likely to be more costly than a term assurance policy Tax treatment of premiums and benefits There is generally no tax relief on premiums for term assurance policies Some policies taken out under personal pension (PP) rules in the past continue to benefit from relief, but no relief is available on new policies The details of the continuation of this relief are beyond the scope of this syllabus area There is no income tax liability on benefits under any form of term assurance taken out by individuals Assignment A policy can be assigned to a lender This does not constitute a chargeable event and has no tax consequences If the policy is still in force when the mortgage is fully repaid, the policy will be reassigned to the borrower There are again no tax consequences of this reassignment Some lenders require policy assignment and they then ensure the policy is adequate and remains in force Others leave the responsibility for this with the borrower(s) Personal IPI (PHI) Personal IPI (Income Protection Insurance) is designed to replace income if the earner is incapacitated and unable to work through illness or injury It is also known as PHI (Permanent Health Insurance) This cover is very useful to protect mortgage payments in the event of incapacity Definitions of incapacity vary, the most expensive being an own occupation definition, where benefits are paid if the individual cannot follow his usual occupation, even if he could follow another occupation The cheapest is any occupation where benefits are only payable if the individual is unable to pursue any occupation (in which case the incapacity would need to be particularly severe to result in a successful claim) Most definitions fall between these two extremes and require that the individual cannot follow his own occupation or any other for which he is reasonably suited by reason of his training, background and experience (or some similar wording) Generally in order for full benefits to be paid out, it is also required that the individual is not pursuing any other paid occupation Cover cannot be cancelled by the insurer (this is what permanent in permanent health insurance means) as long as premiums are paid and the insured follows the same occupation

7 The policy cannot be cancelled because of the claims record of the insured Thus if the insured is incapacitated and makes a claim, but later recovers and returns to work, the cover will resume There will be no requirement for medical evidence in respect of the resumption of cover and cover will continue on the same terms as before However, cover does cease at an agreed termination date, generally chosen to coincide with the expected retirement date of the individual The policy generally requires the insured to notify the insurer of any change of occupation during the policy term and this could result in a change of terms or even the termination of cover The termination date is also the end of the term of the policy Care is needed in comparing premium rates between policies because of the number of variables which can affect rates, for example: - The shorter the deferred period, the higher the premium will be - The later the termination date, the more expensive the premiums - An own occupation definition of disability is more expensive than any occupation - Escalating benefits are more costly than level benefits Benefits are payable after a deferred period agreed at policy inception, and ranging from a few days to 2 years A few insurers provide Day 1 cover which has no deferred period, though the level of benefit available may be restricted to a lower level than for other policies Longer deferred periods mean shorter claims duration and so lower premiums Note that when benefits come into payment at the end of the deferred period, there is no backdating of payments, so the insured needs to support himself through the deferred period Benefits continue until the earlier of recovery, death or the end of the policy term (ie the termination date, usually expected retirement date) Policies can be arranged with escalating benefits, designed to offset the effect of inflation during the payment period If benefits cease as a result of recovery, the cover will recommence On recurrence of the same condition, it may not be necessary to complete a further deferment period before payment of benefits is revived Proportionate benefits are usually payable on partial recovery to enable the individual to return to work on a lower income, perhaps part-time Critical Illness Benefit Critical Illness Benefit (CIB) policies provide a lump sum on diagnosis of certain specified conditions This cover can be arranged to pay off all or part of a mortgage in the event of the borrower suffering from one of the specified conditions The conditions covered vary between providers, but usually include cancer, heart attack, stroke, by-pass surgery, kidney failure, and major organ transplant Total disablement is also usually covered For conditions other than total disablement, incapacity is not required The cover lapses once a claim is paid, but benefits are not clawed back in any circumstances, even if the insured makes a full recovery

8 Cover is available as a rider to life assurance policies, or under a freestanding policy Under the rider basis, the sum assured is paid out on death, or if earlier, when the insured suffers from one of the specified conditions With a joint life policy, the sum assured is generally payable on the first event ie the first death or diagnosis of a specified condition The rider basis is cheaper than separate critical illness and life cover, but on payment of the claim, the life cover would lapse, possibly leaving a gap in total cover (eg for family protection on death) Where cover is freestanding, a minimum period of survival after onset of the critical illness is usually required perhaps one or two weeks Mortgage Payment Protection Insurance Mortgage Payment Protection Insurance (MPPI) is designed to provide cover specifically for mortgage payments at a modest cost It is an annually renewable insurance which can be cancelled by the insurer at the renewal date There are variations between insurers in this market but the details given here are typical Benefits are based on total mortgage costs, including associated costs such as life assurance premiums and buildings insurance The cover may be pitched at a level higher than 100% of these costs, but generally will not exceed around 125% of the costs There will be a limitation based on earnings too, usually around 65% of earnings before the claim The policy pays out if the insured cannot work because of accident, sickness or unemployment as defined in the policy The benefits will be payable for a limited period of (usually) one or two years (but cease if the insured goes back to work within that period) Unemployment cover will be restricted in various ways, and generally excludes voluntary redundancy and redundancy within a few months of policy inception Unemployment resulting from dismissal on grounds of misconduct, a voluntary action such as resignation, or a labour dispute is also likely to be excluded MPPI should not be confused with mortgage protection policies, which are decreasing term assurance policies designed to provide cover for a repayment mortgage if the borrower dies These term assurance policies fall outside this syllabus area ASU insurance Accident, Sickness and Unemployment insurance is essentially the same as MPPI, but with the cover selected by the insured rather than being specifically mortgage linked There are also some redundancy insurance arrangements which just deal with redundancy and limit cover to mortgage costs for one or two years Tax treatment of premiums and benefits All the types of protection covered here are generally pure protection policies, with no investment content There is no tax relief on premiums There is no income tax liability on benefits, except in the case of group IPI (see below)

9 Some IPI policies include an element of investment, though this is usually small When the policy pays out on maturity, or earlier cancellation, there would only be an income tax liability if there was a gain ie the value paid out exceeded the total premiums paid The liability would be at higher rate(s) only (not basic rate) and so would only apply if the individual was subject to higher rate(s) of tax, or was carried into higher rate(s) of tax by the gain It would be unusual for such a tax liability to arise in practice Group IPI is not a personal policy, but is arranged by the employer for all or part of the workforce Premiums are deductible for the employer Benefits are provided as a continuation of salary, and are therefore subject to income tax and NI contribution liability in the same way as salary