More than 25% of homeowners are paying for their homes with an interest-only mortgage say the Abbey. The reason is obvious – their monthly payments are much less. For example, a £125,000 interest only mortgage at an interest rate of 5% and repayable in 25 years time, costs £525 per month - but on a repayment basis the monthly cost rises by £210 to £735 per month.



Understandably, this level of cash saving has proved highly popular with first time buyers struggling to get the feet on the property ladder and others working on a tight monthly budget. But there's a time bomb lurking. 37% of homeowners with interest only mortgages are failing to save any money for repaying the mortgage when the mortgage capital eventually becomes repayable at the end of the term.

The Financial Services Authority (FSA) is concerned about this problem so last year they ushered in new rules requiring lenders to seek evidence from new borrowers about the steps they're taking to repay the capital. And it won't be sufficient for the borrower to say that they intend to repay the mortgage by selling the property. From now on, the FSA is likely to judge any new mortgage that is granted as being miss-sold unless the application includes details of a verifiable repayment vehicle which is likely to generate sufficient to repay the mortgage. And, if the figures don't stack up, the lender will be in hot water with the FSA.

The ideal type of repayment vehicle they will be looking for will be an existing personal equity plan (PEP) or an Individual Savings Account (ISA). Even the 25% tax-free cash from a personal pension plan (PPP) will be acceptable. But borrowers will have to provide evidence to the lender that these financial arrangements are in position – just saying you intend to do it won't wash!

From reactions so far, we can see that individual lenders are interpreting the FSA's rules in different ways. For example, take the Nationwide Building Society: their new rules say that you won't qualify for an interest only mortgage if you plan to repay using an inheritance or are relying on future pay rises. Even if you intend to fund your repayment investment from bonuses rather than from regular income, you'll still be required to show that the bonus scheme exists and that the expected level of savings from bonuses are realistic.

However, the Nationwide Building Society will agree an interest only mortgage if you aren't a first time buyer, the mortgage you want is less than two thirds of the new property's value and you have at least £150,000 of net equity in your existing property.

Lots of mortgage advisers seem to agree that interest only mortgages should only be used as a last resort when income is tight. That's because whichever investment vehicle the borrower uses to repay the mortgage, the investment returns are never guaranteed and it could fail to deliver sufficient capital at the end of the term to fully repay the mortgage. This means there's an element of risk involved. Therefore, many advisers prefer to be sure and recommend a repayment mortgage where there is absolutely no risk of a shortfall.(They may have in mind the desirability of avoiding any risk exposure within the advice they provide although this is covered by their professional indemnity insurance!)

Having said that, some advisers will acknowledge that an interest only mortgage can be useful if the borrower plans to simply shelter under the mortgage's lower repayments as a temporary stop gap of say four or five years, and then switch to a repayment mortgage. Of course, the FSA will still expect the borrower to provide evidence to the lender that a suitable investment or savings plan is in place prior to the borrower releasing the interest only mortgage.

However, in our view, if advisers do recommend an interest only mortgage, they should recommend a scheme where the borrower can make penalty free overpayments. With such mortgages, the borrower is only committed to paying the monthly interest, but as and when spare capital becomes available, money can be paid in to reduce the outstanding mortgage. There are plenty of mortgages available like this. Most allow the borrower to repay at least 10% of capital each year, penalty free, but please check the details before you sign up for the mortgage.