Low costs put pep into home loans

THE popularity of personal equity plan mortgages is waxing as that of endowments is waning, writes Alison Eadie.

The trend is expected to continue as disclosure of commission comes into force in January. The high front-end commission on endowments - typically 66.23 per cent of the first year's premiums - compares with around 3 per cent front-end charge and 1.5 per cent a year thereafter on a Pep unit trust.

Unit trusts are the preferred investment vehicle for the majority of Pep mortgage holders, due in part to the efforts of some managers to package Pep unit trusts with 'term' life assurance and optional loans to make them more user friendly. The three elements can also be purchased separately and often more cheaply for those prepared to shop around.

Pep mortgages are interest- only loans, like endowment or pension mortgages, but the borrower pays into a Pep to accumulate the capital to pay off the loan. The freedom from income and capital gains tax conferred by a Pep allows the investment to grow faster.

Although Pep mortgages met resistance in their early years, particularly from the big four clearing banks, they are now viewed as suitable for a broad range of borrowers and not just the sophisticated. NatWestand Barclays are both developing Pep mortgages.

The Association of Unit Trusts and Investment Funds produces a fact sheet on Pep mortgages explaining how they work. It includes a case study showing monthly repayments on an pounds 80,000 mortgage for repayment, endowment, Pep (packaged) and Pep (unpackaged). The repayment mortgage comes out cheapest, followed by the unpackaged Pep, the packaged Pep and lastly the endowment.

However, Autif's example assumes a 7.99 per cent mortgage repayment rate and it points out that a rise in interest rates could change the balance of advantage.

The performance of the Pep unit trusts is even more crucial. Repayment mortgages leave no scope for extra profit after paying off capital. Endowment mortgages give greater certainty of performance, but Pep mortgages have greater investment potential, Autif says.

Unit trust managers selling packaged Pep mortgages stress their flexibility, tax efficiency and cost-effectiveness. Scottish Provident, which launched its Pep mortgage in July, carried out research among independent financial advisers who expected demand for Pep mortgages to increase from 7 per cent of new business now to 13 per cent in two to three years' time.

Consumer choice of Pep mortgages is increasing. Their flexibility is a strong selling point. Peps allow payments to be increased, decreased, stopped for a while or have lump sums added. They are increasingly being used to top up an existing mortgage and because they are not tied to any one property, they are fully portable.

The risk of a Pep mortgage lies in its exposure to the stockmarket. The underlying investment has to be monitored regularly to make sure it is on target to pay off the capital. If underperforming, payments will have to be increased.