PEP mortgages gain popularity
Sunday 19 March 1995
Although their share of new lending for house purchases remains minuscule at 1 per cent, their share of top-up lending rose to 9 per cent in the third quarter of last year, according to figures from the Council of Mortgage Lenders.
A flat housing market has stopped PEP providers rushing to develop packaged mortgage products, despite opportunities created by the waning of endowment mortgages after disclosures about commission.
The big advantages claimed for PEP over endowment mortgages are tax efficiency, flexibility, lower charges and potentially higher investment returns.
Two-thirds of the premiums paid on an endowment mortgage in the first year go in commission. By contrast, the typical initial commission on a PEP is just 3 per cent.
However, investors should be beware of glib statistics. The growing spotlight on annual charges makes the cost-efficiency argument less clear.
Unit trust PEPs, the predominant vehicle for PEP mortgages, levy an annual management charge between 1 per cent and 1.5 per cent, of which 0.5 per cent goes in commission. Over the life of a 25-year mortgager, as the investment grows, the amount of money paid in annual charges rises significantly.
The flexibility of PEP mortgages is one of their strongest selling points. Payments can be raised or lowered according to investment performance and PEPs can be partly or wholly surrendered without early encashment penalties.
Duncan Howorth, director of Abbey National Independent Financial Advisers, also points out their advantages over repayment mortgages.
If new repayment mortgages are regularly taken out as the mortage holder grows older little capital is paid off and the rate of repayment increases as the repayment period reduces.
PEP mortgages are interest-only loans similar to endowment or pension mortgages, except that in this case the borrower pays into a PEP to accumulate the capital to pay off the loan.
Life assurance can be bought separately or as part of a package provided by some fund managers, including Newton, Fidelity and Scottish Provident.
Packages are designed to be user friendly to those lacking the time or inclination to shop around for the constituent parts. Individuals, or their financial advisers, can still buy PEPs, house loans and life assurance as separate items to ensure they get the best deal on all three.
DBS Financial Management, the largest network of independent financial advisers in Britain, recently launched the first PEP mortgage package backed by investment trusts.
Its PEPs come from Baillie Gifford, Foreign & Colonial, Henderson Touche Remnant and Murray Johnstone.
Life insurance is provided by M & G Life, plus two illness protection options should serious illness prevent the mortgage being paid.
Life cover is priced to cover the difference between the value of the loan and the investment, so that it decreases as the value of the investment increases.
Ken Davy, chairman of DBS, said investment trusts were chosen to make running costs as competitive as possible, as their annual charges are lower compared with unit trusts or life insurance company funds.
More investment-trust backed mortgages are on the way. Dunedin has been promoting its trusts for PEP mortgage purposes for some time. Ivory & Sime expects to launch a PEP mortgage package, with integrated life cover and critical illness options, in April or May.
Reluctance on the part of lenders to accept PEP mortgages is decreasing.
Mr Davy says DBS uses 40 banks and building societies to provide house loans.
Even the big four clearing banks are coming round. In January, National Westminster Bank launched its Personal Mortgage Plan, an investment-based mortgage allowing customers to make their own investment arrangements to pay off the capital. Qualifying investments include PEPs, life assurance, shares, unit and investment trusts, gilts and National Savings.
The NatWest plan is aimed at the well-off. It is only available to those earning more than £35,000 a year and borrowing a minimum of £80,000. The bank is looking at ways of extending investment mortgages to the mass market.
PEP rules, however, stipulate one plan manager per tax year. If a PEP mortgage holder wants to save the occasional lump sump he or she can only invest with the same PEP provider in any tax year.
Most big providers have a range of funds allowing reasonable investment flexibility, but the choice of provider is still limited.
Composition of monthly payments
Based on a 25-year mortgage of £70,000 at 8 per cent interest,
taken out by a man of 35 or a woman of 32.
Repayment Endowment PEP
Interest and Capital £510.06
Interest £426.67 £426.67
Life cover £29.70 £29.50
Policy premium £100.00
Total £539.70 £526.67 £522.07
An endowment requires 7.6% annual return to repay capital, while a PEP requires 10%, which is consistent because PEPs grow tax-free.
Source: Abbey National Independent Financial Advisers Ltd
Sample of projected PEP values
Based on a Dunedin investment trusts PEP, designed to cover
repayment of a mortgage loan of £50,000 in year 25.
Monthly investment £85 £56 £36
Growth rate 6% 9% 12% Over 15 years £22,104 £18,270 £14,803
Over 16 years £24,291 £20,455 £16,906
Over 17 years £26,597 £22,823 £19,246
Over 18 years £29,026 £25,389 £21,852
Over 19 years £31,585 £28,170 £24,753
Over 20 years £34,282 £31,183 £27,984
Over 21 years £37,125 £34,447 £31,581
Over 22 years £40,120 £37,985 £35,586
Over 23 years £43,276 £41,819 £40,045
Over 24 years £46,602 £45,972 £45,010
Over 25 years £50,107 £50,474 £50,538
Annual growth rates are for guidance only, as required by regulators.
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