What is an endowment mortgage? Definition and meaning
An endowment mortgage is home loan where the borrower pays just the interest on the money borrowed, and repays the principal of the loan in one payment at the end of the term with an amount accumulated in a life insurance policy (endowment policy).
While very popular in the 1980s, very few are sold today.
If the mortgagor (borrower) dies during the mortgage period, the life insurance policy is usually used to pay off the whole loan, i.e. the life insurance policy covers payment of the debt outstanding if the borrower dies.
The monthly endowment payments are invested by the insurance company mainly in the stock market. The aim being for it to grow at least enough to be able to pay off the remaining debt at the end of the contract.
The term ‘endowment mortgage’ is used mainly in the United Kingdom and Ireland by consumers and lenders – it is not a legal term.
Two separate arrangements
In this type of loan the borrower signs two separate contracts – one with the lender and another with the endowment policy insurer. The two arrangements are distinct and the borrower can alter either arrangement separately.
In the past, the lender would tie-in the endowment policy to the contract to make sure it was used to pay off the loan at the end of the term. Today, this practice is much less common.
There were two main advantages in this type of mortgage for the borrower:
1. The endowment amount at the end of the term may be more than what is needed to pay off the remainder of the loan. So, the borrower ends up with a surplus (Unfortunately, you can also end up with a shortfall).
2. A proportion of the life insurance premiums are tax deductible. However, these tax benefits have been reduced considerably.
According to collinsdictionary.com, an endowment mortgage is:
“An arrangement whereby a person takes out a mortgage and pays the capital repayment instalments into a life assurance policy and only the interest to the mortgagee during the term of the policy. The loan is repaid by the policy either when it matures or on the prior death of the policyholder.”
Disadvantage of endowment mortgage
As long as the rate of growth of the endowment exceeds the interest rate charged on the loan, all is fine – at the end of the term the insurance policy is big enough to pay off the amount borrowed.
During the 1980s this was not a problem. However, during the 1990s a growing number of mortgagors found that their endowments were growing less rapidly than the interest on their loans. To make matters worse, many lenders failed to warn potential borrowers of the risk.
UK banks have had to pay out billions of pounds in compensation for alleged mis-selling.
Financial regulations were introduced whereby lenders had to send letters to existing endowment holders explaining what their likely maturity values might be.