A mortgage for the daring

Click to follow
The Independent Online
LIKE watching Wimbledon FC, or cooking a perfect souffle, PEP mortgages are not for the uninitiated. The risks may be greater, but then the rewards may be too. Traditional mortgages are safer and require less personal involvement, but PEPs offer unrivalled flexibility and potentially a bigger lump sum at the end of the term.

The very cautious might be better off with standard repayment mortgages. They pay off interest and capital on the loan as they go along. The less cautious may opt for a with-profits endowment, and use it to repay an interest-only loan at the end of the term. Endowments accrue annual bonuses, which temper the risk of exposure to the stock market, making the investment less volatile but still giving some link to the higher returns available from shares.

Only the more adventurous should consider PEP mortgages, which rely solely on the performance of the stock market, without the cushion of bonuses. PEPs offer potentially far greater gains than endowments, in part because of their tax-free status and in part because they are more directly exposed to the stock market. Figures from market researchers Investment Intelligence suggest that if PEPs had been in existence for the past 25 years, investors could have made almost twice as much by putting the same amount into the average equity-income PEP as an endowment.

But the potential downside is also greater with PEPs. If, for instance, there is another October 87-style crash, PEP-holders could find themselves unable to pay off their loan if it falls due soon afterwards.

PEPs are a more flexible repayment vehicle than most endowment and repayment mortgages, in that they allow mortgagees to vary the amount they pay in each month. If PEPs perform better than originally projected, the investor can decrease payments for a while, or pay off the mortgage early. Endowments are less flexible - they should be kept for the full term to earn important final bonuses.

If the borrower loses his or her job and cannot afford to keep up the same level of payments, she or he may have no choice but to surrender an endowment, leading to considerably poorer return than holding it to maturity. Under a PEP mortgage scheme, borrowers may simply pay less. The degree of flexibility depends on the mortgage lender.

With PEP mortgages, you can change manager or fund if you feel they are underperforming, the fee structure changes, or your circumstances change. In addition, investing in a range of different PEPs helps spread the risk.

PEP mortgages have three constituent parts - an interest-only loan (as with endowments), PEPs to repay the capital, and compulsory term or life insurance to underwrite the repayment. The pounds 6,000 annual general PEP allowance - twice that for a couple - is sufficient to repay all but the largest loans.