Backing up an Interest-Only Mortgage

If you are attracted by the idea of combining the purchase of a property with the discipline of regular, long-term saving, you need to decide on the kind of savings plan you are going to use to back the mortgage. Lenders make it very clear that it is your responsibility to make sure you are saving enough to build up the lump sum you will need to repay the loan. If you fail to keep up the payments into the savings plan, or don't pay into a savings plan at all, when the mortgage comes to an end the lender can make you sell your property if that is the only way you have of raising the cash needed to repay the full amount of the loan.

With an Endowment

In the past, the most popular form of savings plan to back an interest-only mortgage was an endowment policy. This is essentially a life-insurance policy linked to stock market investments. The main disadvantages of this kind of savings plan that includes life insurance you may not need and you are tied to paying the monthly premiums for the full term of the mortgage. If you don't, you risk getting back less than you paid in.

Even if you do manage to keep up the monthly premiums, there is no guarantee that your savings will grow sufficiently to produce the necessary lump sum. In recent years, thousands of people have been told that their policies are not on track to repay their mortgages because the underlying stock market investments have not performed as well as had been expected. This endowment scandal has prompted most lenders to give up recommending interest-only mortgages backed by an endowment, in favour by ISA-backed mortgages.

With an ISA

The attraction of the mortgage backed by an individual savings account (ISA) is that an ISA is a more flexible and tax-efficient way of building up the lump sum and an endowment, and it doesn't have to include life insurance. The main disadvantage is that your investments are still tied into the stock market, so there is still no guarantee that you will build up the lump sum you need. You also need to be prepared to keep an eye on how will your investments are performing.

In addition, at the time of writing there is no guarantee that ISAs will continue after 2009, which means you might have to look for another savings plan at some stage.

With a Personal Pension

Using a personal pension to back an interest-only mortgage is tax-efficient, but also very risky. The idea is that you pay into a personal pension (which include stakeholder pensions) with the aim of building up a fund that will be used both to pay you a pension and pay off your mortgage. However, only 25% of this money can be used to pay off the mortgage, so the fund built up in the pension plan is to be at least 4 times the size of your mortgage.

You should also be aware that if you have more than 25 years to go before retiring, you have to play mortgage interest for longer than your would with a mortgage linked to another sort of investment - you will be paying until you decide to take your pension.

Also, if you join an employer's pension scheme, you may have to find another way of saving to pay off your mortgage, because you cannot normally pay into an employer's pension and a personal pension at the same time.