Pension mortgages suit the self-employed

Autumn Property Survey
COMPETITION has introduced more mortgage products, but most people still opt for endowment and repayment mortgages. Other loans accounted for just 16.6 per cent of all new building society mortgages in the first half of this year.

These less popular ones include part-endowment and part-repayment loans, mortgages repaid by investments in unit trusts, mortgages expressed in foreign currencies, or loans paid by lump sums generated by contributions to personal equity plans or pension funds.

Unit trust mortgages were never very common, and although they promised to build investment values very rapidly, allowing borrowers to repay their mortgages ahead of time, they proved equally vulnerable when stock markets fell. Unit trust values dropped along with shares, and borrowers faced the prospect of a shortfall when the time came to redeem.

PEP and pension mortgages have a better track record. Both are tax-efficient. Investors take out what is effectively an interest-only mortgage, on which they pay interest and get tax relief in the normal way. They also buy personal equity plans with annual lump sums or savings plans, and the income and capital accumulates tax-free until the mortgage is due for redemption. Pension contributions are tax-free and the mortgage is repaid from the lump sum on retirement, leaving the balance to provide a pension. But they lack the discipline of an endowment or repayment mortgage, and they rely on the borrower to maintain a realistic level of investment in the PEP or pension plan.

A pension mortgage is not for everyone. But self-employed people with the right disposable income often find this method of loan repayment saves them many thousands of pounds. The mortgage works in the same way as a mortgage loan backed by an endowment policy or a personal equity plan. The customer borrows money and pays interest only to the lender. But instead of repaying the capital at the end of the term, the loan is paid off with the lump sum received from the individual's personal pension fund when he or she retires.

The advantage of the pension-backed mortgage is the high level of tax- efficiency. The lump sum is paid free of tax, which means those on a higher marginal rate of income tax put in just pounds 60 for every pounds 100 invested. The pension repayment mechanism can be transferred when the owner moves or remortgages, unlike a repayment mortgage, which has to be repaid when the customer moves.

House purchasers interested in pension mortgages must be confident of remaining self-employed, or at least committed to a personal pension scheme. If there is a possibility that at a later date the individual may join an employer with an advantageous company pension scheme, it is short-sighted to commit oneself to a personal plan to pay off the mortgage.

Another drawback may be the level of contributions required for the capital sum to cover the loan. The maximum lump sum available from a personal pension fund on retirement is just 25 per cent of the total fund. The rest of the money must be used to purchase an annuity or retirement income plan. So if the mortgage value is pounds 150,000, the final pension fund must be worth pounds 600,000.

Even if the pension fund will reach the necessary size on retirement, the investor has to decide whether he or she really wants to commit most of (or perhaps all of) their tax-free capital to repaying the loan rather than earning a pension in retirement. Some lenders will only advance 80 per cent of the lump sum for that reason. Mortgagees should also be aware that benefits can only be taken from their pension, and capital paid off, between the age of 50 and 75. A term assurance policy is normally required with the pension mortgage.

Paul Wainwright, pensions director of Chase de Vere, says that although only 1 per cent of mortgages are pension-backed, they are usually as acceptable to mortgage lenders as repayment, endowment or PEP-backed products. "As long as they've got the security of the house, there's not a problem." he said.

Mr Wainwright advises people choosing pension mortgages to fund their pensions as generously as possible, to compensate for the amount of cash they will be withdrawing. This money spent repaying the loan would otherwise help to support them in retirement.

Recently it has become possible to take out a mortgage repaid by the proceeds of a second-hand endowment policy originally issued to someone else, which borrowers can now buy. Several specialist policy traders, including Exeter-based TEP Mortgage Line and Policy Portfolio in North London, offer advice on how to proceed.

Investors need a substantial sum to buy the policy and must then take over responsibility for paying the premiums until the policies mature. There may also be a liability to capital gains on the maturity value of the policy. But the policies can grow rapidly in value. It is best to consult a mortgage broker or an independent financial adviser.