Endowment Loan

An endowment loan, also known as an endowment mortgage, is a type of mortgage in which the borrower only pays the interest on the loan each month. Instead of making payments on the principal, the borrower makes regular investments into a savings plan, or endowment, which will mature when the mortgage matures. The borrower then uses the funds from that endowment to pay off the mortgage’s principal.

Endowment loans have primarily been popular in the United Kingdom. Consumers using them often opted to buy what the British call a life assurance policy (the equivalent of a whole life insurance policy in the U.S.) to accumulate the savings necessary to pay off the principal. This life assurance policy would be set to mature simultaneously with the mortgage.

In order to authorize an endowment loan, a lender will require proof that the borrower has a realistic plan for repaying the principal. This plan cannot rely on an expected inheritance or windfall.

Say a borrower chooses to buy a home that costs $150,000, financing the purchase with a 25-year endowment mortgage. The lender issuing the mortgage sets the monthly payment at $850 (reflecting a prevailing interest rate of 6.8%). This sum covers only the interest on the loan; the borrower must cover any relevant taxes and insurance themselves.

Meanwhile, the borrower has also acquired a life assurance policy that will mature in 25 years. He makes monthly payments of $250 into this policy because the company issuing the policy has calculated that monthly payments of this amount, with the anticipated yield through interest, will guarantee that the policy will have a cash value of $150,000 or more at the end of 25 years. If at the end of 25 years, the markets have been steady, the policy will mature, and the borrower will use the $150,000 that has accumulated to pay off the principal. Any amount in the policy over $150,000 will go to the borrower. Any shortage will require that the borrower pay off the difference in cash.

[Important: With an endowment loan, the borrower's monthly payments only go towards interest on the loan; the principal is paid off in one lump sum when the mortgage matures.]

The good part. Endowment loans offer many incentives for borrowers. The chief one is, of course, the lower monthly payments since they are only paying interest instead of interest and principal on the loan. Of course, they still must pay into a life assurance policy or another form of savings plan in order to demonstrate that they are planning for the final principal payment at the loan’s maturity.

But an enforced savings plan is rarely a bad thing, and it could even be profitable: Many people have entered into endowment loans believing that the money they save through their life assurance policy will end up being more than the principal of their mortgage. In these cases, the borrower would receive an additional lump sum after the mortgage principal is paid off.

The risky part. Despite these benefits, endowment loans can be riskier than traditional mortgages. Any sort of investment or savings plan can lose value over time depending on the market: What if there's a major correction, causing a portfolio's holdings to plummet, just when the mortgage is coming due? Similarly, abrupt changes in interest rates could skew the projected growth rate of a life insurance policy's cash value. If the policy loses value, the borrower may be left with a shortfall when the mortgage matures. In this case, they would need to have another source of cash to be able to pay off the mortgage.

This very scenario hit thousands of British homeowners in recent years. In the late 1980s, endowment mortgages were an extremely popular way to finance a home purchase, fueled by booming stock and real estate markets (and some special tax breaks for the product); more than one million endowment savings plans or policies were sold in one year. But, by the late 1990s, it became clear that these plans were going to fall short of their optimistically projected growth rates—and the amounts of the mortgages they were supposed to cover. In the 2010s, many homeowners were forced to find other ways to repay their mortgages or risk losing their residences.

Many regulators and financial analysts condemned endowment loans as a case of mis-selling, not unlike the situation with variable universal life insurance policies that unfolded in the U.S. about the same time. Very few endowment loans are sold in the U.K. today.