Insurance Practice &

Mortgage Lending Theory

Lectures 3 & 4: Methods of Payment

 Quick Overview
Capital Repayment Mortgage

 Monthly repayments include both capital and interest payments.

 If the borrower keeps making the required repayments, the is
guaranteed to be paid off at the end of the mortgage term.
 Life insurance should be arranged to protect the interests of the
borrower’s family.
 Quick Overview
Interest-Only Mortgage

 Only interest payments are made through the term of the loan. The
capital has to be repaid in one lump sum at the end of the term.
 Borrowers need to pay into an investment (repayment vehicle)
every month so that there are sufficient funds available when the
capital is due for repayment.
 Interest-only loans are granted subject to a credible repayment plan.
 Endowment Policies
Guarantee
Without profit that the
mortgage is
repaid at the
Full with-profits end of the
term.

Low cost with-profits

Low start policies

Unit-linked
No basic sum assured.
 Shortfall Risk
 The value of the investment product is likely to be lower than the
capital due to the lender at the end of the term due to endowment
underperformance (e.g. increased uncertainty in capital markets,
lower return on investment).
 To reduce or eliminate the risk of shortfall, endowment providers,
following a policy review, may ask to:
 Increase monthly payments.
 Extend the term of the mortgage.
 Repay some of the mortgage with a lump sum.
 Change part of the loan to capital repayment.
 Wait and see
 Pension Plans
 Only 25% of the pension fund can be taken as a tax-free cash
lump sum.
 The pension must accrue a value of at least four times the
amount of mortgage capital to be repaid.
 Benefits can only be taken after the age of 55.
 Requires the highest monthly provision of all the repayment
methods (mortgage + pension).
 Since 2006, UK rules allow people to contribute to both an
occupational (workplace) and a personal pension scheme.
 Term insurance also has to be added to the package.
 Individual Savings Accounts (ISAs)

 Cash ISAs; Stock & Shares ISAs; innovative finance ISAs

(peer-to-peer lending); lifetime ISAs.
 Proceeds free from income tax (e.g. interest on cash &
innovative finance, dividends on stocks).
 Holders can contribute, subject to a maximum annual limit
(£20,000 in 2020/21), as much and for as long as they want.
 ISAs can only be in single names. For a joint mortgage,
applicants can take out two ISAs if necessary.
 Unit Trusts
 A collective investment medium, pooling the money of many
small investors to form a large fund for investment.
 Investment at better rates benefited by economies of scale,
spread of risk and professional investment management.
 The trust is managed by the unit trust manager and the
investment is held by the trustee (subsidiary of the trust).
 The investor can buy as many units at the offer price as their
investment permits.
 Units can be sold at any time back to the manager at the bid
price.
 Bid-offer spread: usually 5% - 7.5%.
Open-Ended Investment Companies (OEICs)

 Limited companies available in the UK since 1997.

 Like unit trusts, they allow small investors to pool their
investments and obtain better returns, more widely spread risk
and professional investment management.
 They are managed by the Authorized Corporate Director and
the assets of the company are kept safe by the depository.
 Investors buy and sell as many shares in the company as they
want at the (usually single) share price which depends on the
value of the underlying investments.
 Many unit trusts have now converted to become OEICs.
 Time Value of Money

 A pound today is worth more than a pound tomorrow – money

available today can be invested to earn interest.
 The ability to earn interest on money is referred to as the time
value of money.
 The interest rate can be thought of as a price that balances the
supply and demand for loans.
 The rate of interest should reflect:
 The productivity of capital (basis of the demand for loans).
 The preference for consumption today (basis for supply).
 Determining Interest Rates

Interest rate
Saving = Deposits = Lending

Saving = Deposits = Lending (next period)

r
r1
Investment = Borrowing

M M1 Saving and Investment

11
 Future Value Factor
The future value of £1 invested for n periods at an
interest rate of r, will be equal to:

FVn/r = £1 × (1 + r)n

where n is the number of time periods (e.g. months,

years) in the future.
r is the rate of interest
Future Value at Different Discount Rates
 Future Value Factor - Examples

 What will £800 invested at an interest rate of 12% grow

to by the end of year 5?
 FV = £800 × (1+0.12)5 = £1,410

 You deposit £1,000 to your bank account at 2%. What

will you account balance be after 10 years if you make no
further transactions?
 FV = £1,000 × (1+0.02)10 = £1,219
 Present Value Factor
The present value of £1 due in period n at an interest
rate of r, is equal to:

PVn/r = £1 / (1 + r)n

where n is the number of time periods (e.g. months,

years) in the future.
r is the rate of interest
Present Value Factor at Different Discount Rates
 Present Value Factor - Examples

 What is the present value of £10,000 due in 4 years from

now if the interest rate is 3%?
 PV = £10,000 / (1+0.03)4 = £8,885

 You have to pay 8,000 for your child’s tuition fees in 2

years from now. How much do you need to save today if
you can receive 10% on your savings?
 PV = £8,000 / (1+0.10)2 = £6,612
 Annuity

 A series of constant payment made at equal intervals for a

specified number of time periods.

 Example:

£500 £500 £500 £500 £500

0 1 2 3 4 5 years
 Annuity - Example
 What is the present value of an annual cash flow of £500
received at the end of the next 5 years if the interest rate is
10%?
 1st method:
PV = £500/(1+0.10) + £500/(1+0.10)2 + £500/(1+0.10)3 +
£500/(1+0.10)4 + £500/(1+0.10)5 = £1,895.4
 2nd method:
PV = £500 × PVAF5/10% = £500 × 3.7908 = £1,895.4
 Present Value Annuity Factor
 Formula:

where n is the number of time periods (e.g.

months, years) in the future & r is the rate of interest.
OR
 Discount Tables:
Look at the combination of the appropriate row
(period) & column (interest rate).
 Estimation of Mortgage Payment
 Suppose a capital repayment mortgage of £50,000 with 25 years
mortgage term and 6% fixed interest rate. What should be the
annual payment so that the loan is repaid by the end of the
mortgage term?
 PV = the amount of loan (mortgage) received today.
 Therefore:
PV (Loan) = Annual Payment × PVAFn/r
£50,000 = Annual Payment × PVAF25/6%
£50,000 = Annual Payment × 12.7834
 Rearranging and solving for Annual Payment:
Annual Repayment = £50,000 / 12.7834 = £3,911.32
 Estimation of Mortgage Payment
Capital Repayment Vs Interest-Only Mortgage

 We show that a capital repayment mortgage of £50,000

requires an annual payment of £3,911.32 (monthly =
£3,911.32 / 12 = £325.9) in order to be fully repaid in 25
years at 6% interest rate.
 What would be the annual payment for a similar* interest-
only mortgage?
*Loan = £50,000; Mortgage Term = 25 years; Interest Rate = 6%

 Interest-only mortgage annual payment = £50,000 × 0.06 =

£3,000 (monthly = £3,000 / 12 = £250).
 Estimation of Mortgage Payment – Excel (example)
 Enter the number of years in cell I2 = 25
 Enter the interest rate in cell I3 = 6%
 Enter a random annual payment amount in cell I5. E.g. I5 = 1,000
 Enter the PV function in cell I4 as follows:
 Rate = I3 Nper = I2 Pmt = I5
 with I5 = 1,000 you will notice that I4 = 12,783. This means that
with an annual payment of 1,000 you can only repay a capital of
£12,783.
 To find the payment required for the repayment of the loan, open
the Goal Seek (Data/What-If-Analysis) and enter the
details as show in the next slide:
Estimation of Mortgage Payment –
Excel (illustration)
Capital Repayment (Annuity) Mortgage – Excel
 Capital Repayment (Annuity) Mortgage
Calculations Guidance

 Interest Paid = Capital outstanding at start of year ×

interest rate
 Capital Repaid = Annual Payment - Interest Paid
 Capital outstanding at end of year = Capital outstanding at
start of year – Capital Paid
 Capital outstanding at start of year t = Capital outstanding
at end of year t-1
 Capital Repayment (Annuity) Mortgage – Illustration

Capital o/s at end of year

89
9 ,0 23
50,000 4 ,1 99
48 7 ,0 13
4 ,0 63
46 4 ,8 43
4 3 ,6 50
45,000 4 2 ,3 0
4 , 98 8
40 , 52 8
39 , 98 6
40,000 37 , 35 6
36 , 62
34 2
35,000 , 79
32 84
8
,
30 78
8
,
30,000 28 4
, 60
26 9
, 28
24 5
25,000
, 83
21 3
, 23
20,000 19 6
, 47
16 3
, 55
15,000 13 5
, 45
10
10,000 1 71
7,
0
69
5,000 3,

0
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25