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Some aspects of financial advice may not need to be tailored.

Christmas 1989…

I know this is a busy time, so thanks for seeing us.

I understand you would like some independent financial advice?

That’s right, we don’t really understand the difference between endowment and repayment mortgages.

It’s not really so complicated. Under the repayment method, you pay a small amount every month to reduce your debt. These sums accumulate and become larger as the interest element of your monthly payment falls. Over twenty-five years, this repays the whole loan. If you have an endowment mortgage, you pay a premium to an insurance company instead. The company invests the money. The proceeds should be more than enough to discharge the mortgage at the end of twenty-five years.

So we should take the endowment mortgage if we think shares are going to do well?

You’ve got it in one. With an endowment mortgage, you are in effect borrowing money from the building society to invest in shares. The attractiveness of this depends on what financial economists call the ‘equity premium’ – the difference between the return on equities and the level of interest rates.

So how large is the equity premium?

Historically, the equity premium has been in the range 6% – 8%. But most economists think that this figure is too high to be sustained. A more reasonable assumption might be 5%, or even less.

If shares will return 5% more than building society rates, taking money from the building society to buy shares must make sense.

It’s not quite as simple as that. When I began selling life insurance, there was tax relief on the money you borrowed and a tax subsidy to life insurance policies. That made the choice a no-brainer: even if there wasn’t any equity premium at all, the government made the endowment route worthwhile.

All that’s changed, hasn’t it?

Yes. Now you don’t now get tax relief on borrowing over £30,000 and the insurance subsidy has gone. You need to pay a margin to the building society and also the insurance company’s charges.

So how do the sums add up?

Suppose the equity premium is 5%. You should expect to pay perhaps 2% – 3% in tax, 1% – 2% for the building society’s cost and profit, and 2% – 3% for the insurance company’s charges.

Doesn’t sound such a good deal to me. And the endowment mortgage is riskier, isn’t it?

Difficult to say. The biggest risk with any mortgage is that you lose your job, or your marriage breaks up. Or house prices may fall. In these circumstances, you will have slightly more flexibility with a repayment mortgage, but there is not really much to choose between them.

Your main concern should be that repayments never become unaffordable. If inflation gets out of hand, you will find yourself struggling to meet your obligations under either repayment or endowment mortgage: but if you go for an endowment you will probably be better off in the end. That was the experience of people who took out mortgages twenty years ago.

Ten years later

How nice to see you again. Bet you can’t wait to visit the Millennium Dome.

It’s just past the new Financial Services Authority building at Canary Wharf, isn’t it? Talking of the Financial Services Authority, thank you for advising us ten years ago. Incidentally, our neighbours the Smiths have just had an “amber letter” and they’re suing the man who sold them an endowment mortgage.

I’d worried you might be suing me. I gave you the most objective advice I could, but you might have been better with an endowment mortgage. The equity premium, at 6.2% over the 1990’s, was higher than I expected. Taxes were lower, interest rates fell and insurance company charges were down.

So why are they suing?

Well, I still take the view that what I said ten years ago was right. Once you take account of tax and charges, you have to be very optimistic about the future level of the equity premium to borrow money to invest in shares. So the advice the Smith’s got was bad, and such advice is generically bad.

But even if it was bad advice ten years ago, it’s actually worked out pretty well for the Smiths, because shares did better in the last ten years than could reasonably have been expected. And as interest rates have fallen, their monthly outlays have fallen too.

Yes, Mr Smith told me that. They used to pay more than us but now they pay less.

That’s right. What the Smiths need to do is to save some of that difference to make sure they really will be able to pay off their mortgage at the end of the term.

That’s what the amber letter is about. So was the Smith’s policy an example of misselling?

I don’t know, and really nor does anyone else. The key issue is the future level of the equity premium, because what happens towards the end of the mortgage term matters far more than what happens in the first ten years. I think it’s bad advice ever to tell anyone to work on the basis that the equity premium will be higher than 5% – bad for you, bad for Mr Smith, bad in 1989, and bad now. But the FSA won’t let me say that. I have to tailor my advice to your particular circumstances.

I don’t know how you financially clever people keep on top of all these things.

Sometimes I’m not sure we do.

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