Money: Pick your home loan with care

Will the new ISA mortgages fill the gap left by PEPs? asks Faith Glasgow

One of the most popular and efficient ways of funding a mortgage in recent years has proved to be the personal equity plan (PEP). But the many borrowers who are repaying their loans through regular contributions to PEP accounts face an uncertain time in April, when PEPs and tax-exempt special savings accounts (Tessas) are replaced by their less bountiful cousins, individual savings accounts (ISAs).

The PEP mortgage is similar to an endowment mortgage in that the borrower pays only interest on the loan to the building society and funds the capital repayment through monthly payments into a separate stock market-based investment; but that investment is wrapped in a PEP rather than an insurance policy. The theory is that at the end of the term, the investment will have prospered on the back of shrewd fund management and a thriving stock market and grown to more than cover the original capital sum owed.

One big attraction of the PEP mortgage is its tax-free status. Investors can put up to pounds 6,000 into a general PEP and a further pounds 3,000 into a single company PEP each year without having to pay tax on either income or capital growth. By contrast the insurance company has to pay tax on an endowment fund, so there is a regular leak from the cash pool.

The other plus is that PEP mortgages are flexible. You can pay in additional lump sums, increase your monthly contribution, take time out from payments or even withdraw money if necessary, as long as you do not exceed the annual allowance. By comparison, endowment policy holders are seriously penalised if they cannot keep up monthly payments or need to redeem the policy.

But fact that PEPs are so accessible can be a temptation for less disciplined savers. And they are relatively volatile - there is always the chance that all your stock market gains may be wiped out by a single unfortunately timed market crash. Endowment policies grow by a calculated bonus each year, which enables the insurance company to smooth the ups and downs of the market over the policy's life.

None the less, many people have opted for PEP mortgages over the last five years or so. But are they necessarily wise to make the jump to ISAs in April?

ISA mortgages will operate along similar lines to PEP predecessors but there are lower limits to what you can stash away free of tax (pounds 7,000 falling to pounds 5,000 annually). ISAs have the advantage, however, that a wider choice of investments is eligible for inclusion. They may also turn out to be slightly less expensive because recommended management charges of a maximum 1 per cent have been laid down in the Government's guidelines. Annual charges of up to 1.5 per cent are the norm under the PEP regime.

There is a feeling among mortgage brokers, nonetheless, that not every PEP mortgage holder will slide smoothly into the ISA successor. David Archer, at mortgage adviser John Charcol, believes ISA mortgages will have their place and will be suitable for some clients. However, he thinks they will not prove as popular as PEP mortgages. In part, he says, that is because the tax-free allowance is so much lower with ISAs than with PEPs and Tessas, and people may not wish to use the whole thing to fund their mortgage.

Secondly, says Mr Archer, the demise of PEPs has made clear the limited life of ISAs and brings into question their suitability for paying off a mortgage over 25 years. Another consideration is that from April the tax treatment of PEPs and ISAs will change for the worse, so that any dividends (the income generated by shares in the fund) will be subject to 10 per cent tax; in five years this will go up to 20 per cent.

What should current PEP mortgage holders do? Any existing PEPs will continue as they are but mortgage holders need to make alternative arrangements after April if they are to avoid the risk of a capital shortfall when it comes to repayment. You may well have been contacted by your financial adviser or fund manager, giving you the option to continue investing into the equivalent ISA with the same manager. If you are happy with performance then it probably makes sense to do that. It will not happen automatically, however. You will have to complete an application for the ISA.

If you are not satisfied, of course, this is a good time to take your custom elsewhere. Remember that ISA mortgages, like PEPs, depend on the vagaries of the stock market. If you are not comfortable with that uncertainty, then choose a less risky alternative.

PACKAGES AT A PRICE

Many companies sell packaged mortgages - a bundle including mortgage, in-house PEP, life assurance and other optional protection such as critical illness or mortgage protection cover, all in one. A lot of them will do the same for ISAs: Legal & General, for instance, has just announced plans for a new flexible ISA-based mortgage, to be launched this month. It will include an ISA that tracks the FT-SE All Share index, plus built-in life cover.

But packages do not generally offer as good all-round value or performance as you would find if you shopped around for each element separately and constructed your own deal. Choose an ISA fund that aims for steady capital growth - a tracker fund is a good bet.

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