Pension mortgages have a certain cachet. They are aimed mainly at higher earning professionals with substantial future earning potential. They offer major tax incentives for both the mortgage and pension aspects and can fit into an overall financial planning process. But are they being purchased by the wrong people?
According to financial advisers, most pension mortgages are taken out to help finance a commercial property. Most popular with professional partnerships, the loan is taken out for, say, 20 or 25 years which coincides, ideally, with the retirement date of the borrowers. As with an endowment mortgage, only interest payments are made to the lender, and tax relief, at the full rate, is claimed on the payments. By linking the commercial mortgage to a pension, the advantage is that aside from also enjoying the full tax relief on the pension contributions, the tax-free lump sum proceeds of the pension (25 per cent of which must be used to pay off the loan) are not subject to CGT, the way an ordinary commercial endowment fund payout would be.
Arranging a pension mortgage on a self-employed person's private home also means tax advantages you get tax relief on the mortgage interest and the pension contributions for the full period of the loan. Private residential pension mortgages are less common, say financial advisers, but nevertheless, demand is increasing. And this, they say, is worrying.
"It's really a bit of minefield," says Mr Paul Coghlan of the independent advisers Financial Planning Strategies. "The only really suitable candidates for a pension mortgage on a private residence are professionals whose income stream is going to increase substantially in the future."
Such a person is most likely to be a solicitor, barrister, doctor or dentist in their late 30s to mid-40s, says Mr Coghlan, earning at least £50,000 a year. Chances are they will aim to retire by 60 - and the pension mortgage will retire with them after 15 or 20 years. It is this group that can realistically expect their income to keep going up over the period and their pension lump sum (i.e. the 25 cent of the fund) should have no difficulty paying off the loan.
Unfortunately, pension mortgages are being arranged for people who do not fit this income category: self-employed people, working in mainly service industries like sales, computers, even small accountants are taking out these mortgages despite the uncertainty of their future earning capacity.
One such case involves Mr B, a software consultant who took out a pension mortgage worth £70,000 five years ago when he was 45 and began working for himself. His pension contributions are £350 a month and he expects to retire at 65.
According to Mr Coghlan, to be on the safe side, most lenders require that the final pension fund be projected at five times the value of the loan before they will issue the finance, even though this is excess of the sum required to provide a lump sum that will cover the actual borrowings.
"In your reader's case this means a pension fund of £350,000. But assuming that his fund, after five years is worth £20,000 - and that in itself is a big if - his current contributions, growing at 8 per cent net, will only produce about £187,000 over the 15 years. Add that to the current value of £20,000 and he is still well short of the target value of £350,000." His fund is also well short of the absolute minimum of £280,000, out of which he will be able to take a £70,000 lump sum at retirement.
Pension mortgages that cannot meet the value of the loan at retirement must be paid off with other resources.
Mr Coghlan is critical of the banks and building societies for not taking a stricter view of pension mortgages taken out against private residences. If you do take out a pension mortgage, he advises, make sure that:
your income is high to start with and will keep growing;
that the growth assumptions on the pension fund are conservative no more than 7.25 per cent, and;
make sure it is reviewed annually.
Anything less and you put both your home and your retirement plans at risk.
