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.

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

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.