What is ‘Endowment Loan’
An endowment loan, also known as an endowment mortgage, is a type of mortgage in which the borrower only makes monthly payments on the interest of the loan. Instead of making payments on the principal, the borrower makes regular investments into a savings plan, or endowment, which will mature when the mortgage matures. The borrower then uses the funds from that endowment to pay off the mortgage’s principal.
These types of loans have primarily been popular in the United Kingdom.
BREAKING DOWN ‘Endowment Loan’
Endowment loans offer many incentives for borrowers, however, they can be riskier than traditional mortgages. When repaying an endowment loan, borrowers may assume they’ll have lower monthly payments, since they don’t make payments on the principal. However, they still must pay into a life assurance policy or other form of savings in order to demonstrate that they are planning for the final principal payment at the loan’s maturity. In order for a lender to authorize an endowment loan, they’ll require proof that the borrower has a realistic plan for repaying the principal. This plan cannot rely on an expected inheritance or windfall.
Many people have entered into endowment loans believing that the money they save through their life assurance policy will end up being more than the principal of their mortgage. In these cases, the borrower would receive an additional lump sum after the principal is paid off. However, life assurance policies can lose value over time depending on the market. If the policy loses value, the borrower may be left with a shortage when the mortgage matures. In this case, they would need to have another source of cash on hand to be able to pay off the mortgage.
An Example of an Endowment Loan
A borrower may choose to purchase a home for $150,000 with a 25-year endowment mortgage. Given current interest rates, the lender sets the monthly interest payment at $850. This covers only the interest on the loan. The borrower must cover any relevant taxes and insurance themselves. Meanwhile, the borrower has also acquired a life assurance policy that will mature in 25 years. They make monthly payments of $250 into this policy because the company issuing the policy has declared that monthly payments of this amount, with the anticipated yield through interest, will guarantee the borrower $150,000 or more at the end of 25 years. If at the end of 25 years, the markets have been steady, the policy will mature, and the borrower will use the $150,000 that has accumulated to pay off the principal. Any amount in the policy over $150,000 will go to the borrower. Any shortage will require that the borrower pay that off in cash.