Tax-free but not without worries

Ten million people have a mortgage, several million now have tax- free personal equity plans, and the combination of the two in the form of a PEP mortgage has been around for years. But it is still a modest slice of the total mortgage market in spite of the obvious attractions of paying off the loan with the proceeds of a totally tax-free investment instead of a conventional endowment policy.

One reason for the slow take-up of PEP mortgages is probably the strong trend away from products, which repay the mortgage in full only at the very end of the term, in favour of the traditional repayment mortgage, which starts reducing the size of the loan with the first payment.

This in turn can be traced back to the alarming revelation that, because of the drop in inflation and in the returns on investments, some "low- cost" endowment policies, mostly those taken out since the mid-Eighties, might not actually grow fast enough to pay off the mortgage at the end of the term, let alone provide the fat surplus that most projections bandied around in the early Eighties.

In fact these fears may have been exaggerated. Only a handful of maturing endowment mortgages so far have failed to cover the debt, and most insurance companies are still suggesting that policies maturing in the next few years will cover perhaps 1.1 or even 1.2 times the loans they are linked to. But the fall in property values over the last five years and the phenomenon of negative equity also tilted the balance back in favour of repayment mortgages, where slowly but surely negative equity is reduced as the debt shrinks.

PEP mortgages may have suffered along with endowment mortgages, especially as the value of the PEP can actually fall visibly if the underlying investments are doing badly. PEP mortgages are also seen as relatively inflexible, with no scope to extend the payment term, and lacking the automatic life insurance cover which endowment mortgages provide.

The wheel of fortune may now be turning back as the property market recovers and negative equity begins to diminish. The appeal of PEP mortgages has increased visibly because the strong showing of the stock market has put real profits into the pockets of PEP investors.

Next week Standard Life is hoping to capitalise on the trend by launching a mortgage package called Homebuilder PEP combining a PEP invested in Standard's own managed unit trust and fed by regular premiums, with a special mortgage protection policy to protect the payments against a sudden loss of earnings. There is also a critical illness option.

Other eventualities are covered by the option to increase and extend the mortgage, make early repayments, and take payment holidays. The plans can be used to finance a property purchase or a remortgage of an existing property. The minimum mortgage term is five years, the maximum 35 The minimum starting age is 19 and the maximum 75, although critical illness cover is only available to under-60s.

Borrowers are expected to pick their own lender, which could include fixed-rate or discount loans. The PEP is invested in a relatively expensive unit trust with an initial charge of 5.5 per cent, an annual management charge of 1 per cent and a bid-to-offer spread of 6 per cent (including the initial charge).

But Standard Life expects to sell as many as 10,000 PEP mortgages next year compared with around 50,000 of its existing Homeplan unitised endowment mortgages. Anyone interested can apply to a Standard Life branch, call freephone 0800-333353, or go to an independent financial adviser.