With a very hot property market in the UK prices continue to rise at a dramatic pace. This is making it difficult for first time buyers to get on the property ladder and has left many people scrambling to get interest only mortgages with their lower monthly premiums. This article discusses the merits and pitfalls of interest only mortgages and warns of the financial ruin or forced trade down that taking one out could potentially in.
Borrowers entering Never-Never Land
Mortgage lenders willingness to market interest only home loans has prompted fears that these mortgages could be the cause of the next misselling scandal. Concerns about the rapid growth, in this type of lending, have prompted the Financial Services Authority (FSA) to launch and investigation into the market. It has highlighted interest only mortgages as one of the top "emerging retail risks" and has pointed out that there has been a dramatic increase in the number of this type of mortgage being taken out without a linked repayment vehicle (for example, an endowment). It expects to produce a report on the sector in early 2007.
The Financial Ombudsman Service (FOS) says it has received hundreds of complaints about interest only mortgages. It says some people are complaining that their lender had promised to put a repayment mechanism in place but had failed to do so. The Ombudsman also reported people saying the risks had not been pointed out to them.
One of the problems is that these types of financial transaction do not pay off the principal loan amount and in many ways shouldn't be referred to as a mortgage at all. People will often refer to themselves as making monthly payments to "pay off the mortgage" when they are paying against an interest only mortgage, whereas in reality they are not.
Interest only mortgages have also become popular with the popular phenomenon of buy-to-let investors because they can offset interest payments directly against rental income and, if they own several properties, they can sell one to meet repayments. But it is the first time borrowers that are giving the authorities cause for concern. Until the 1990s borrowers who took out an interest only mortgage were required at the same time to make payments into a pension or endowment policy and that would pay off the principal. This helped pay off many home loans, but of course, in later years endowment mortgages dramatically undershot investment targets.
In July 2006 16 per cent of mortgages taken out by first time buyers were interest only with no repayment vehicle running in parallel. People in the industry are warning that these types of borrower could find themselves obliged to sell their homes to repay the original loan.
With the average first time buyer now borrowing more than 3.2 times their salary, which incidentally is the highest ever to get on the property ladder, the pressure remains string. As at October 2006 first time buyers are paying an average £135,000 to get on the property ladder. While at the same time the average national house is priced around £220,000, but even higher in the South East.
The superficial appeal of an interest only loan is clear. On a 25 year mortgage with an interest rate of 5% the repayment mortgage would cost around £877 whereas the interest only option would come in much lower at £625. The problem is that at the end of the 25 years the repayment borrower would own their home but the interest only borrower would still be saddled with the £150,000 debt. In a rising market people are willing to accept this, but in a market, which will inevitably go down, people will not.
It has been suggested that the under 35s won't compromise their lifestyles. They think the value of the property will continue to go up. As many borrowers do not plan ahead even the lenders are getting concerned. Some have commented that people are blind to the fact that property prices could go down and some younger borrowers always seem convinced they will inherit sufficient funds within the lifetime of the mortgage to pay off the debt. People forget that with an interest only mortgage if someone moves the moving costs, agents fees, solicitor fees and stamp duty could eat up any equity they have gained.
According to the Council of Mortgage Lenders (CML) interest only mortgages are even more popular with people moving home. In July 2006 22 per cent of home-movers took out interest only mortgages with a "repayment vehicle not specified" compared to 16% of first time buyers
Summary
With the risk of higher interest rates and/or a declining property market this is a house of cards that is likely to fall down within a generation. The risk to the borrower is if they hit one of these market troughs at a critical time, the conclusion of this article therefore had to be that anyone looking at taking out an interest only seriously considers another investment vehicle to pay off the loan principal. It is best to go the whole hog and set up something that will target paying off the total at the end of the mortgage period, but at the very minimum people should make a monthly contribution alongside the interest only payment to a tax efficient investment vehicle like an ISA.
There are no figures available for the total number of homebuyers with interest-only loans. However, figures for new interest-only house purchase loans have been running at between 10 and 20 per cent for all new first-time buyers over the past 10 years, and roughly the same for other homebuyers.
With more than half of all mortgages now arranged through an intermediary, mortgage brokers could be in the firing line for claims of mis-selling if the homebuyer's loan reaches maturity and there is not enough cash to pay off the loan.
The CML is keeping close tabs on the situation and has set up a shortfalls working group to look into ways of encouraging consumers to act now to address any shortfall on interest-only mortgages.
"We are suggesting that when a mortgage comes up for review, for example, when it reaches the end of a concessionary rate, then it would be prudent to check on how the borrower intends to repay the loan," said a spokesperson for the CML.
Using an interest-only mortgage will keep your monthly payments down until you can afford the higher monthly payments of a repayment mortgage.
But because you're not paying anything off the amount you owe, you will probably end up paying more interest in the long run.
Interest only mortgages are a high-risk strategy that could come back to haunt advisers that set up the arrangement. An increase in interest rates could also hit these clients hard as they would have no fall-back option of reverting to an interest-only mortgage.
Simply enough, to combat the issue clients must be told that if they can not afford to pay for a mortgage, don’t take one out.
Here’s what you need to know. With an interest-only mortgage your monthly payments only cover the interest on the loan and do not actually pay off the loan itself.
If you take this option you will need to make separate arrangements to pay off the loan when the mortgage ends. You can make your arrangements through your lender – but it isn’t compulsory.
If you don't arrange the funds at the end of the mortgage you may very well lose your home. Essentially, the money you pay to the interest only mortgage goes no where – you may as well rent.
You will have a substantial amount of time (depending on the actual agreement) to save regularly in order to make payments into a savings or investment scheme in order to build up a lump sum to pay off the mortgage when the time comes.
However, the returns offered by banking or building society accounts are usually too low to be used to pay off the amount borrowed.
Instead, it is common to accept some risk in the hope of a higher return by choosing schemes where returns are linked to the stock market. Although the risk is with these stock market linked schemes, there is no guarantee that your money will grow enough to pay off the mortgage in full by the end of the mortgage term.
Another option is to change to a repayment mortgage later. This might be a suitable option if your earnings are low now but are expected to be much higher in future.
Using a lump sum from somewhere else such as an inheritance or selling something such as another property or a business is another option and is also a risky one. You need to be sure that the inheritance will materialize and think about what would happen if your business was to fail.
Selling the property to pay off the loan is probably your last option. This is suitable only if you won't need to live in the property such as if it is a buy-to-let property or a second home, or you are buying something cheaper.
Whatever plans you make to repay your mortgage, remember to review them from time to time to make sure that they are still on track. In the first place, interest only loans should be a last resort and should always only borrow what you are guaranteed to be able to pay back.
Both Adrian Hudson & Michael Challiner are contributors for EditorialToday. The above articles have been edited for relevancy and timeliness. All write-ups, reviews, tips and guides published by EditorialToday.com and its partners or affiliates are for informational purposes only. They should not be used for any legal or any other type of advice. We do not endorse any author, contributor, writer or article posted by our team.
Adrian Hudson has sinced written about articles on various topics from Debts Loans, Legal Matters and Mortgage. Adrian Hudson originally started in I.T Management, but after recognising a niche for a company with a finance and I.T mix, in 1997 he formed his own successful consultancy business. He is currently spending most of his time working on the contracts and b. Adrian Hudson's top article generates over 33100 views. to your Favourites.
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