Chances are you've heard of an endowment mortgage, but you're not quite sure what it is. Nowadays this unique type of mortgage is in the news everywhere and is receiving a bad rap from many people. So what's the truth about an endowment mortgage, and how does it really work?

Endowment mortgages can be somewhat complex, although the system behind them is simple. They work in two parts. On one hand, they are a simple interest-only mortgage, and are treated as such. The borrower pays interest on the mortgage to his lender, and any terms that can apply to a normal mortgage are applied to these interest payments, including capped rates, fixed rates, variable rates, and any other special incentives the lender may offer. However, the borrower is not paying off his mortgage with these payments, as he would be with a typical mortgage: He is only paying the interest.

The mortgage itself is paid separately, and only at the time it ends. During the term of the loan, the borrower makes separate payments into an endowment fund. This fund is invested in stocks, shares, and life insurance, and allowed to mature throughout the term of the mortgage. At the close of the mortgage term, the endowment is cashed in to pay off the mortgage.

The downside here is obvious: If the endowment investments don't do well, then the endowment will not pay off the total balance, and the homeowner will still be responsible. Today's extremely low interest rates and sluggish stock market have turned some people away from the idea of endowment mortgages.

However, there are advantages to this unusual type of plan. Throughout the years of your mortgage, your monthly payments remain low (only the cost of interest) and will not be a strain in your income. The money you set aside for your endowment is, essentially, working for you; regardless of how well the market performs, chances are good that you will get back more than you paid in. Also, lenders that offer endowment mortgages offer borrowers a few escape clauses. If your endowment is in progress, and the stock market is doing poorly, you may be given the option to opt out of your endowment and invest your money instead in an additional savings plan which accrues interest on your payments. It won't gain you as much as an endowment potentially could, but it will protect you against poor investment performance. Most lenders will also allow you to switch your entire mortgage, or just the amount of the projected shortfall, to a standard repayment mortgage.

For the financially organized, endowment funds can be a great way to pay your way through owning a home and come out clean on the other side. With an endowment mortgage, just as with any other investment, it pays to keep a close eye on your cash.