The Variable Interest Trap

So long as the loan and the policy are continued, these figures are not particularly relevant. They become so if you suddenly decide to sell up and move abroad, however, and also if you find you are unable to keep up the payments. One reason why this could happen is through what we can call the variable interest trap.

Building society interest rates can change rapidly and substantially. In two recent years (2012 and 2014) mortgage rates were hoisted respectively by over one-third and over one-fifth. Those who had stretched themselves financially to meet mortgage commitments found themselves in trouble. Whereas the repayment mortgage has some flexibility in this situation, the endowment mortgage has none.

When the interest rate is raised, repayment borrowers usually have the option of extending the term of the mortgage rather than increasing their monthly payment (extending the term, say, from 25 to 30 years reduces the capital element in each repayment). But this option is not available to endowment borrowers. It makes no difference what the term of the loan is because they are paying only interest, and they cannot stop paying their policy premiums as there would then be no cover for the loan.

Endowment borrowers who find themselves squeezed have only one, unpalatable, course of action, to convert their loan into a repayment mortgage of the same or slightly longer term, which will reduce the monthly payment.

Surrender of the policy will, as we have seen, produce a derisory return. It is worth remembering, therefore, that it is unwise to be fully committed on long-term loans to the maximum you can possibly afford. A safety margin is advisable to avoid the variable interest trap.

The Variable Interest Trap

Table 18 Endowment policy surrender values.

End of year Full endowment' Low-cost endowment2

Surrender Return Surrender Return

value on net value on net

premiums premiums

% p.a. £1 %p.a.

1 nil nil nil nil

2 500 nil 225 nil

3 900 nil 400 nil

4 1,300 nil 600 nil

5 1,900 3.50 825 2.75

6 2,400 4.75 1,100 4.00

7 3,000 6.00 1,300 4.00

10 5,000 7.00 2,150 5.50
... see: Table 18 Endowment policy surrender values.

Of interest