"Best-advice" and the "true" mortgate term. Actuaries' endowment advice principles revisited

In 1999 the Financial Services Authority recommended that a standard repayment mortgage was the “best advice” for Independent Financial Advisors to give to essentially all new mortgage customers seeking the best value repayment vehicle. The FSA simply followed the recommendation of the 1999 Report of the Endowment Mortgages Working Party of the Faculty and Institute of Actuaries. This working party compared the relative returns and risks with repayment and endowment mortgages over a standard twenty-five year term. Endowment mortgages benefit from compound rates of growth, and so the underlying capital value available for repayment increases disproportionately the longer returns are allowed to accumulate. In selecting between repayment and endowment mortgages, the true mortgage term of repayment therefore becomes the critical determinant of which repayment vehicle is actually the best value. Crucially, the FIA assumed that any variation in the length of mortgage would lead to a reduction in the standard twenty-five term, thus giving further weight to the preference for repayment mortgages as exhibiting better value. This study challenges the FIA’s Working Party assumption about the typical term of repayment in two ways. First, we draw on economists’ recent developments in consumer theory to show that the variation in needs-based expenditure among households is large enough to allow for a considerable cohort of the house-owning population to select to extend their mortgage term beyond twenty-five years. There is therefore no reason in theory why twenty-five years ought to be the upper limit for mortgage debt repayment. We then present the results of a study of a sample of mortgage applicants in the South East of England. These individual case study data are extremely rare, and so the results particularly valuable; and the principal result is that the “true” mortgage term for the largest single cohort of consumers is longer than 25 years. The results indicate that among those applicants trading up (around half of all mortgage applicants) the average extension associated with each move is two years. When this 27 year period is then taken as the standard repayment term, the results of any comparison of the effectiveness of repayment and endowment mortgages changes dramatically in favour of equity-backed investment plans. Simulations based on historic data demonstrate that endowment plans are 19.2% and ISA plans 21.6% more efficient than straight repayment mortgages over the longer period. Furthermore, the risk of an equity-backed investment plan under-performing is halved when the typical mortgage term is extended from twenty-five to twenty-seven years. We therefore conclude that while the FSA’s “best advice” is indeed applicable to many borrowers, for the majority the reality is that equity-backed methods of mortgage repayment represent a significant improvement compared with the currently favoured repayment mortgages.