With this type of interest-only mortgage, you pay into an individual savings account (ISA) to build up enough to pay off the mortgage at the end of its term. ISAs are a tax-efficient way in which to invest in shares, unit trusts and many other investments: tax-efficient, because all the income and growth from the underlying investments is for now completely tax-free.
ISAs replaced personal equity plans (PEPs) from April 1999 onwards. From that date no new PEPs could be started but old PEPs can continue. You can earmark any PEPs you already hold, as well as any ISAs you now take out, to repay your mortgage. With both PEPs and ISAs, dividends from shares are tax-free only until April 2004, but from then on they are due to become taxable. Other income and gains will continue to be tax-free.
Despite the tax advantages which ISA mortgages, and in the past PEP mortgages, have over endowment mortgages, borrowers have been slow to switch to them.
Cynics suggest that this is because the commission paid to mortgage advisers is lower on an ISA or PEP mortgage than on a traditional low-cost endowment mortgage, but there is more to it than that. People are cautious by nature about new ideas and, until the introduction of bond-based PEPs and ISAs this type of mortgage was always a higher-risk option than a with-profits endowment mortgage. Unlike the with-profits endowment, where the addition of bonuses gives you an increasing value over the years, the investments in a share-linked ISA or PEP can fall in value as well as rise.
Over the long term, shares, unit trusts and investment trusts are likely to show good returns and might be expected to beat the more broadly based investment funds underlying with-profits endowment policies. But, at any point in time, stock markets may fall, and the value of your ISA or PEP along with them. So although your payments into an ISA (and in the past to PEPs) will be pitched at the level expected to produce a fund large enough to pay off the mortgage at the end of the term, there is a significant element of uncertainty about the future. However, since there are no restrictions on withdrawing money from your ISA or PEP, as the end of the mortgage term approaches you could make a practice of cashing in part or all of your investment when share prices are high and reinvesting in a lower-risk alternative. Share-linked ISA mortgages are suitable only for people who would place themselves around six or more on a ten-point risk scale.
You can use ISAs - and, since 6th April 2001, PEPs also - to invest in medium-risk investments such as corporate bonds, gilts and preference shares. But it is doubtful that these investments would produce a high enough return over the mortgage term to make this type of mortgage worthwhile, bearing in mind the relatively high cost of borrowing now that mortgage tax relief has been abolished.
There is no built-in life cover with an ISA mortgage. If you have dependants, consider taking out term insurance.
Payments into an ISA are generally very flexible. This has the advantage that, if you run into temporary difficulties, it is easy to cut down or suspend payments into the ISA for a while. The flipside of this is that you need the self-discipline to ensure that you pay steadily into the ISA enough to build up the sum needed to repay the mortgage at the end of the day.
This flexibility is particularly valuable since the abolition of tax relief on mortgage interest. There are no longer any tax advantages in keeping a mortgage for the long term. If you can afford to, it makes sense to pay off your mortgage as rapidly as possible. An ISA mortgage gives you the necessary flexibility to completely repay your mortgage before the original term is up.
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