How to repay a mortgage with a flexible friend

MORTGAGES which are based on Personal Equity Plans are gaining in popularity, particularly among those with large loans and "top-up" borrowers.

Their share of the total home loans market remains small, however. Figures from Housing Finance for the second quarter of last year show PEP mortgages accounting for 1 per cent of new lending compared with 61 per cent for endowments and 25 per cent for repayment mortgages.

Increasingly, though, PEP mortgages are seen by lenders as a necessary part of the product range. National Westminster Bank this month launched its Personal Mortgage Plan, an investment-based mortgage allowing customers to make their own investment arrangements to pay off the capital. The interest is paid by an interest-only loan from the bank. Qualifying investments include PEPs, life assurance shares, unit and investment trusts, gilts and National Savings.

The Plan is aimed at the well-off and financially sophisticated. It is only available to those earning more than £35,000 a year and borrowing a minimum £80,000. NatWest said it was looking at ways of extending investment mortgages to the mass market.

It is the first of the big four clearing banks to accept PEPs as a mortgage repayment vehicle, although big building societies have been happy to accept them for some time. 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. Life assurance can be bought separately or as part of a package available from some financial nstitutions.

The main advantages of PEP mortgages over endowments are said to be tax- efficiency, flexibility, lower charges and potentially higher investment returns.

The star of the PEP mortgage was expected to rise at the start of this year after disclosure of commissions for life companies revealed the full extent of front-end loaded commission paid to those selling endowments. An endowment typically pays 66 per cent of first-year premiums in commission, against typical PEP front-end commission of 3 per cent.

However, the growing spotlight on annual charges makes the cost-efficiency argument less clear-cut. Phillip Cartwright, manager at London & Country Mortgages, stresses the importance of performance and warns that the argument over commissions is spurious. "We do not sell PEP mortgages on the basis that they are cheaper than endowments," he said.

Unit trust PEPs, the vehicle for most PEP mortgages, typically levy an annual management charge of 1 to 1.5 per cent, of which 0.5 per cent goes in commission. Over the life of a 25-year mortgage, as the value of 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 the early encashment penalties imposed by life offices.

PEP rules, however, stipulate one plan manager per tax year. If a PEP mortgage holder wants to save the occasional lump sum for retirement, or any other purpose, he can only invest with the same PEP provider in any tax year. Most big PEP providers have a range of PEP-able funds allowing reasonable investment flexibility, but the choice of provider is limited.

PEPs, as equity-based investments, fluctuate with the stock market. If the PEP performs well, the tax-free sum could end up substantially greater than required to pay off the mortgage.

In the long run the tax benefits of a PEP should ensure it outperforms an endowment, but PEP mortgage borrowers may feel more exposed unless they have an external monitor to make sure their PEP is on target to repay the capital sum. Although the investment performance of endowments has been under fire, life offices smooth the fluctuations of the stock market, making endowments appeal to those less comfortable with an element of risk.

The risk factor is, however, being addressed. Fidelity's PEP mortgage offers a capital protection option to protect gains during the final years. The advent of PEP corporate bonds should also allow investors to switch into lower-risk investments towards the end of a mortgage.

Providers of packaged PEP mortgages, offering PEP, home loan and life assurance in one bundle, are not reporting a stampede for business, but point out that the housing market is flat. Mary Blair, director of product development at Fidelity, says the average size of a Fidelity PEP mortgage is £100,000 and most of its borrowers are buying for the second time or topping-up an existing loan.

Consumer choice of PEP mortgages is increasing, as are the arguments about the best and cheapest way of organising them. But at present PEP mortgages show no signs of becoming a mass market product. They do, however, offer a flexible alternative to the mainstream mortgage vehicles.