An endowment mortgage is a mortgage in which the borrower pays only interest to the lender during the life of the mortgage and applies separate payments to an endowment policy. The policy matures when the mortgage ends, paying off the principal on the loan, and sometimes providing a surplus which is paid to the owner of the policy. In the event that the borrower dies before the mortgage is finished, the policy pays out immediately.
In an endowment mortgage, the borrower has two different agreements. One is with an insurance company for the endowment policy. Usually when the borrower starts shopping for houses and loans, the insurer provides what is known as a preprojection letter, describing the amount which should be present in the endowment when it matures. The borrower also works out an arrangement with a lender for an interest-only loan, using the preprojection letter as evidence that the principal will be paid off when the endowment mortgage matures.
Over the course of the endowment mortgage, the borrower receives regular reprojection letters which indicate whether or not the endowment is on track. If interest rates change, for example, these letters may be adjusted to reflect the fact that the endowment will come up short when the loan matures because it is not making enough money. This requires the borrower to pay more into the policy in order to ensure that enough money will be present when it matures.
When the principal payment becomes due and the policy matures and pays out, it is possible to have a surplus, either because of a rise in interest rates or because of benefits which may have been awarded, such as a bonus for a year in which the overall endowment fund earned more money than expected. This surplus can be retained by the borrower after paying the lender back. If the endowment matures and there is not enough money, the borrower will need to make up the difference on the endowment mortgage.
Endowment mortgages are very different from repayment mortgages, in which borrowers send in money to the lender every month to pay off part of the principal and some of the interest. Interest-only mortgages have been criticized in some regions because sometimes they are not well administered or the numbers are massaged during the application process to allow someone to take out a mortgage which is actually too large to handle. However, they can be a useful tool for some borrowers, and a financial adviser can provide more information about options.