Interest-only mortgages: a disaster waiting to happen?

Julia Harris, mortgage analyst at moneyfacts.co.uk, comments on the growing interest only mortgage market, and explores the difficulties that consumers may face in the longer term if they take this option to buy their home.

“In our ‘live for today’ culture, priority for many is still to get on the property ladder and consumers and lenders are using everyway possible to make this happen. But with incomes already stretched and prices continuing to rise, consumers are desperately trying to secure the cheapest mortgage option in terms of monthly repayments.

“Many are taking out mortgages over extended terms, up to 50 years in some cases and opting for interest only repayments. Lenders are continuingly increasing income multiples and relaxing terms, as reactions to both the economic stability and growth we have seen in the property market and also the ever increasing competition between lenders. Although these may all allow the consumers to get themselves on the property ladder, and may well be affordable in the short term, it may also be lulling people into a false sense of security and in the long term things could look very different.

“While the use of interest only mortgages is not something new, and has historically been used successfully, the change has been surrounding the repayment vehicle. The early 90’s saw regulatory change and consequentially the rules were relaxed on lenders having to hold a legal charge over an investment vehicle.

“Previously the regulatory requirements stipulated that if borrowers were to have an interest only mortgage, the lender would take a charge over the investment vehicle and ensure that over time the borrower was making sufficient payments to repay the capital amount. In 1992 79% of first time buyers were using an interest only mortgage with an accompanying repayment vehicle, compared with just 5%1 in 2005. The endowment mis-selling debacle won’t have helped these statistics, but today’s reasons for opting for an interest only product are driven by affordability (or lack of it).

“But rather more alarmingly, the statistics for buyers using interest only repayments without the use of a specified repayment vehicle now account for 15%1 of first time buyers and 22%1 of home movers. But the actual figures could be much higher, as although the lender may ask for details of the repayment vehicle, many will not require proof or make any subsequent check that repayments to this are being made or that they will ultimately repay the loan.

“While the use of interest only mortgage may lower the repayments, consumers still need to factor in the additional cost of funding any repayment vehicle they have. Taking for example a average mortgage of £150K over a 25 year term, charged at 5%, the monthly interest only repayment would be £625, while capital repayment would be £251.89 more at £876.89.

“Many consumers may choose interest only initially, with the intention to move to capital repayments in the near future, when their financial situation improves. But should they wish to keep the same repayment term, they need to be aware of just how much the costs will rise in the future. Take for example the same 25 year mortgage, but for the first 10 years only interest payments are made; for the next 15 years to repay capital and interest the monthly repayments would shoot up from £625 to £1,186.19 per month. This would also equate to an additional £25,447.20 in interest costs over the term.

“Consumers can soon become comfortable with the lower monthly repayments, but unless careful future planning and budgeting is used, they may find they can’t afford to pay off the loan by the end of the term, leading possibly to mortgage defaults and ultimately in the worst-case scenario, repossession. CML figures reported 8,140 properties were taken into possession in the first half of 2006, compared with 5,190 in the previous six months and this is expected to increase to a staggering 15,000 in 2008.

“The jump from interest-only to capital repayment can be a huge. Borrowers can soften the blow by using the option of partial repayments which many lenders now offer, allowing the borrower gradually to build up the percentage of the capital that is paid at a rate comfortable to their circumstances.

“An alternative option, providing low initial repayments would be a fixed or discounted deal with extended tie in, but although these rates of say 1.89% may appear attractive, the exit fees, set up fees and higher rate during the tie in period could soon take a shine off those very attractive low monthly payments experienced during the first couple of years.

“But all said, taking into account the risks involving opting for an interest only mortgage could help those renting onto the property ladder. If you simply can’t afford to purchase your property on capital repayment terms, is the interest only option actually any worse than renting? By repaying interest only, you are not subject to landlord terms, are able to make improvements to the property and as long as you are fully aware that you may need to convert back to rented accommodation if the repayments become unaffordable come retirement if your income levels drop.  There is also scope for capital appreciation, an opportunity you would not see should you rent, but on the downside if there was a sharp downturn in property prices, you could be faced with a situation of having to pay for rent and some negative equity.

“While interest only may be the only plausible option for many to be able to step on to the property ladder, in order to prevent major problems in the longer term the mortgage market needs to ensure the consumer is fully aware of their situation, the consequences of just paying the interest and the true cost of fully paying off the mortgage. Consumers perhaps should receive regular advice and documentation, detailing their position and the costs/risks they may face. Britannia Building Society has recently taken steps to address the problem and has plans to write to everyone of its interest-only customers to make them aware of the problems they may face if do not start to pay off some of the capital.

“Consumers also need to keep their wits about them. Mortgage deals that don’t seem to be plausible often aren’t, and you need to look at the long term picture. Moneyfacts’ research shows there are over 8,000 mortgage products available, so with a little time invested and some sound independent financial advice, consumers should be able to find a deal that matches their financial aims for the future.”

NOTES TO EDITORS:

Moneyfacts Group
Moneyfacts is the UK’s leading independent provider of personal financial information and our data is used and trusted throughout the financial industry. 

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