Other Financial Products

Question 1

What is a pension?

Answer 1

A pension is an investment fund where contributions are made, usually throughout the individual’s working life, to provide a lump sum on retirement, plus an annual pension payable thereafter. In many countries, pension contributions are generally tax efficient – they reduce the amount of an individual’s taxable income and, therefore, the amount of income tax paid.

Question 2

State Pension Schemes

Answer 2

A state pension is provided in many countries to provide people in retirement with the funds to live.
The provision will obviously vary from country to country, but one of the common features in many countries is that state pensions are provided out of a government’s current year income, with no investment for future needs.

Question 3

Corporate Pension Schemes

Answer 3

One of the earliest kinds of scheme supplementing state funding was the occupational pension scheme. Corporate retirement schemes or occupational pension schemes are run by companies for their employees

Question 4

What are the advantages of corporate pension schemes?

Answer 4

1. Employers contribute to the fund (some pension schemes do not involve any contributions from the employee – these are called non-contributory schemes).
2. Running costs are often lower than for personal schemes and the costs are often met by the employer.
3. The employer must ensure the fund is well-run and, for defined benefit (DB) schemes, must make up any shortfall in funding.

Question 5

Personal Pensions

Answer 5

Private pensions or personal pensions are individual pension plans. They are DC schemes that might be used by employees of companies that do not run their own scheme, or they might be used in addition to an existing pension scheme, and by the self-employed.

Question 6

Individual Retirement Accounts (IRAs).

Answer 6

Individual retirement accounts (IRAs) are found only in the US and are effectively a type of personal pension scheme. They are established by individual taxpayers, and contributions can be made up to a maximum amount which can qualify for tax deduction. Contributions to a traditional IRA may be tax-deductible depending on the taxpayer’s income, tax filing status and coverage by an employer-sponsored retirement plan.

Question 7

Types of Borrowing

Answer 7

Individuals can borrow money from banks and other financial institutions in three main ways:

1. Overdrafts
2. Credit card borrowing, and
3. Loans.

Question 8

Overdrafts

Answer 8

When an individual draws out more money than they hold in their bank account, they become overdrawn. Their account is described as being in overdraft.

Question 9

Unauthorised Overdrafts

Answer 9

Unauthorised overdrafts are very expensive, usually incurring both a high rate of interest on the borrowed money, and a fee. The bank may refuse to honour cheques written on an unauthorised overdrawn account, commonly referred to as ‘bouncing’ cheques. In some countries, issuing cheques when there are insufficient funds in the account is a criminal offence.

Question 10

Authorised overdrafts

Answer 10

Authorised overdrafts, agreed with the bank in advance, are charged interest at a lower rate. Some banks allow small overdrafts without charging fees to avoid infuriating a customer who might be overdrawn by a relatively low amount due to a mistiming between payments in and out.

Question 11

Unsecured loans

Answer 11

Unsecured loans are typically used to purchase consumer goods. The lender will check the creditworthiness of the borrower – assessing whether they can afford to repay the loan and interest over the agreed term of, say, 48 months from their income, given their existing outgoings.

Question 12

What is a mortgage?

Answer 12

A mortgage is simply a secured loan, with the security taking the form of a property.
A mortgage is typically provided to finance the purchase of a property. For most people, their main form of borrowing is their mortgage on their house or flat. Mortgages tend to be over a longer term than unsecured loans, with most mortgages running for 20 or 25 years.

Question 12

Repayment Mortgage

Answer 12

The most straightforward form of mortgage is a repayment mortgage. This is simply when the borrower makes monthly payments to the lender, with each monthly payment comprising both interest and capital.

Question 13

What are the main risks attached to a repayment mortgage from the borrower’s perspective?

Answer 13

The main risks attached to a repayment mortgage from the borrower’s perspective are:

1. The cost of servicing the loan could increase, since most repayment mortgages charge interest at the lender’s standard variable rate of interest. This rate of interest will increase if interest rates go up.
2. The borrower runs the risk of having the property repossessed if they fail to meet the repayments – remember, the mortgage loan is secured on the underlying property.

Question 14

Interest-Only Mortgages

Answer 14

As the name suggests, an interest-only mortgage requires the borrower to make interest payments to the lender throughout the period of the loan. At the same time, the borrower generally puts money aside each month into some form of investment.
The borrower’s aim is for the investment to grow through regular contributions and investment returns, such as dividends, interest and capital growth, so that at the end of the mortgage, the accumulated investment is sufficient to pay back the capital borrowed and perhaps offer some additional cash.

Question 15

Offset Mortgages

Answer 15

An offset mortgage is a simple concept which works on the basis that, for the calculation and charging of interest, any mortgage is offset against, for example, any savings you may hold.

Question 15

What are the main risks attached to an interest-only mortgage from the borrower’s perspective are?

Answer 15

1. Borrowers with interest-only mortgages still face the risks that repayment mortgage borrowers face – namely, that interest rates may increase and their property is at risk if they fail to keep up the payments to the lender, and
2. An additional risk that the investment might not grow sufficiently to pay the amount owing on the mortgage. In the example above, there is nothing guaranteeing that, at the end of the 25-year term, the investment in the fund will be worth £100,000 – indeed, it might be worth considerably less.

Question 16

What are the main benefits to offset mortgages?

Answer 16

1. A higher-rate tax payer will not incur tax on any savings interest earned because it has been offset against the mortgage borrowing.
2. As interest is being paid on a slightly lower mortgage, it provides some flexibility to manage finances, pay off the mortgage a little quicker and have more control.”

Question 17

What are the four main methods by which interest on a mortgage may be charged?

Answer 17

1. Variable rate
2. Fixed rate
3. Capped rate, and
4. Discounted rate.

Question 18

What are the differences between Islamic banks and conventional banks?

Answer 18

1. Islamic banking is asset-backed, which means that an Islamic bank does not carry out business unless an asset is purchased to allow the transaction to be conducted according to Shariah law.
2. The source of the Islamic bank’s funding, profits and business investments cannot be in/from businesses that are considered unlawful under Shariah law, such as companies that deal in interest, gambling, pornography, speculation, tobacco and other commodities contrary to Islamic values.
3. The whole premise of Islamic banking is to provide a way for society to conduct its finances in a way that is ethical and socially responsible. Trade, entrepreneurship and risk-sharing are encouraged, and these are the financial principles that underpin Islamic finance and the products offered by Islamic banks.

Question 19

Murabaha

Answer 19

Where the bank buys the property, but then sells it on to the customer at a higher price. The buyer repays the higher figure in a series of instalments, typically over a 15-year period. Since only the capital is being repaid, there is no interest.

Question 20

Ijara

Answer 20

Where the bank leases the property in return for a rental payment for a specified financing period. The bank promises to transfer the title of the property at the end of the financing period, if all payments have been made.

Question 20

Life Policy

Answer 20

A life policy is simply an insurance policy where the event insured is a death. Such policies involve the payment of premiums in exchange for life cover – a lump sum that is payable upon death.
Instead of paying a fixed sum on death, there are investment-based policies which may pay a sum calculated as a guaranteed amount plus any profits made during the period between the policy being taken out and the death of the insured. The total paid out, therefore, depends on the guaranteed sum, the date of death and the investment performance of the fund.

Question 21

What are the three types of whole life policy?

Answer 21

1. Non-profit that is for a guaranteed sum only
2. With-profits which pays a guaranteed amount plus any profits made during the period between the policy being taken out and death, and
3. Unit-linked policies where the return will be directly related to the investment performance of the units in the insurance company’s fund.

Question 22

Variable Rate Mortgages

Answer 22

1. In a variable rate mortgage the borrower pays interest at a rate that varies with prevailing interest rates. 2. Once they have entered into a variable rate mortgage, the borrower will benefit from rates falling and remaining low, but will suffer the additional costs when rates increase. The interest rate charged may also track the movement in the official base rate of the central bank, when it is sometimes known as a ‘tracker’ mortgage

Question 23

Fixed Rate Mortgages

Answer 23

1. In a fixed rate mortgage, the borrower’s interest rate is set for an initial period, such as the first three or five years. 2. If interest rates rise, the borrower is protected from the higher rates throughout this period, continuing to pay the lower, fixed, rate of interest. However, if rates fall and perhaps stay low, the fixed rate loan can only be cancelled if a redemption penalty is paid. The penalty is calculated to recoup the loss suffered by the lender as a result of the cancellation of the fixed rate loan. 3. It is common for fixed rate borrowers to be required to remain with the lender and pay interest at the lender’s standard variable rate for a few years after the fixed rate deal ends commonly referred to as a ‘lock-in’ period

Question 24

Capped Rate Mortgages

Answer 24

1. Capped mortgages protect borrowers from rates rising above a particular rate – the ‘capped rate’. 2. For example, a mortgage might be taken out at 6%, with the interest ratebased on the lender’s variable rate, but with a cap at 7%. If prevailing rates fall to 5%, the borrower pays at that rate, but if rates rise to 8% the rate paidcannot rise above the cap, and is only 7%

Question 25

Discounted Rate Mortgages

Answer 25

1. Lending institutions often attract borrowers by offering discounted rate mortgages. A 6% loan might be discounted to 5% for the first three years. 2. Such deals might attract ‘switchers’ – borrowers who shop around and remortgage at a better rate. They may also be useful for first-time buyers as they make the transition to home ownership with a relatively low but growing level of income

Question 26

Life Assurance

Answer 26

Life assurance and protection policies are designed and sold by the insurance industry to provide individuals with some financial protection in case certain events occur. Although product details may vary from country to country, the general principles of what the individual (and their adviser) should be looking for in the products and their main features tend to be consistent

Question 27

Term Assurance

Answer 27

Term assurance is a type of policy that pays out a lump sum in the event of death or serious illness occurring within a specified period. Term assurance has a variety of uses, such as ensuring there are funds available to repay a mortgage in case someone dies or providing a lump sum that can be used to generate income for a surviving partner or to provide funds to pay any tax that might become payable on death.