Fears grow of red letter days for mortgages

HOME buyers are heading for a cold hard winter despite last week's reduction in borrowing costs. Millions of households are unlikely to enjoy cuts to their monthly mortgage bills for many months yet, house prices throughout the UK fell for the third month running in November, and a new report brought more gloomy news for endowment policyholders.

Big mortgage lenders moved swiftly to announce cuts to their standard rates from the beginning of next year.

Yet the credit crunch continues, with little sign that either fixed deals or discounted trackers have room to tumble.

And now a new headache has arrived with a bleak report on endowment mortgages from financial analysts at Money Management.

Report author Alice Ross concludes: "Millions of low-cost endowment policyholders have been left in doubt as to whether their policies would be of any real value at all, let alone pay off the mortgage at maturity as had once been assured."

Two of the biggest endowment companies, Standard Life and Norwich, now have an eye-watering 1.4 million contracts underwater.

Elsewhere, Scottish firms have little to be proud of. A third endowment giant, Guardian, which sold endowments for the UK's biggest building society Nationwide, refused to take part in the survey. It is now owned by Aegon Scottish Equitable, which also refused to take part in the study.

All of which raises an urgent question for the 3.6 million policyholders still paying into the now discredited contracts: should they continue contributing or surrender?

It is not all bad news. Most policies maturing this year have managed to pay out a target sum of £50,000. And some firms, such as CIS, the Prudential and Scottish Amicable, continue to perform well.

But many which are further from maturity are heading deep underwater and will not meet their targets.

Companies are required to write to customers warning them of potential shortfalls. If the contract needs to grow by 8% annually to pay off the mortgage, which it is unlikely to do in the current economic climate, you get a red letter.

If it requires 6% annual growth, which is ambitious but not improbable, you get an amber letter warning there is a chance the policy will fall short.

You get a green for go if 4% growth is all that is required, as this should be achievable.

Nine out of 10 of Norwich Union's 764,609 policyholders are now receiving red letters, while at Standard Life the proportion is 88%. At Friends Provident, 89% are badly underwater.

We can only guess at the plight of policyholders with Guardian, because it declines to disclose the information, along with any data relating to its parent group Aegon Scottish Equitable.

However, a spokeswoman for the company said the omission was due to "an administrative oversight".

By contrast, LV has only green policies on its books, largely as a result of an endowment guarantee. However, it only sold 4,492 policies in total.

Scottish Life has seen a massive rise from 13% to 79% in red policies, although it claims to be using different criteria to judge their current status. It now uses a more cautious 4.5% to 5% projection before it will class a contract as amber.

Prudential is the star performer. Only 15% of its customers are on red warnings and 19% on amber. Similarly, only 10% are red at Scottish Amicable, and 36% amber. CIS also does well, with only 15% red, although 61% of its contracts are amber.

However, it would be wrong to assume that all these contracts are a disaster, certainly for those closer to maturity.

Within the Norwich Union stable, CGNU contracts have achieved an annual yield after tax of 8% over 25 years, as have Children's Mutual, Prudential, NFU Mutual and Scottish Amicable. This compares with the 7.3% average return before tax is deducted from a building society over the past 25 years.

Elsewhere, Norwich Union contracts have yielded 7.5%, as have Legal & General and Clerical Medical contracts. Standard Life has produced annual growth of 6.8%, and Friends Provident 6.4%.

By contrast, Winterthur has endowments earning just 4% annually, as have three brands now owned by the zombie fund Phoenix Life, including Life Association of Scotland, Crusader and National Provident Life.

All of which leaves the crucial question: should I stay or should I go? In order to help with this decision, Money Management has for the first time produced an additional piece of information called the "critical yield", which is the growth the policy must achieve from here on in to reach its target.

The critical yield should indicate how much a contract needs to grow annually to meet its target over 25 years, depending on its performance to date after 10 years, 15 years, 20 years and 24 years.

Take Standard Life: after year 24, a typical endowment has achieved annual growth of 6.4% and requires only 3.4% (the critical yield) in the final 12 months to reach its target, which seems doable.

After 15 years, it has clocked up 5.2% annually, and needs 6.2% each year until maturity to reach its target, which is more questionable.

However, at 10 years it has yielded just 1.8% annually and now requires a critical yield of 6.8% for the next 15 years. This looks like a bigger ask.

A similar picture emerges at most other offices. Take the CGNU brand at Norwich Union. Having achieved a 7.6% yield after 24 years, it has a negative critical yield of -10.5%. In other words, even if values fall sharply in the last year it will still pay out, and will probably mature with a nest egg on top.

However, after 10 years that rosy picture is sharply reversed. It has produced a negative return of -0.5% and will require an 8% annual yield over the next 15 years to meet its target. That looks ambitious.