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The rise and fall of interest-only mortgages
Interest-only mortgages where borrowers only service the interest on their debts but do not repay the capital were a feature of the credit boom before 2008. Despite a clampdown by lenders, they are still available.
by Michelle McGagh on Dec 14, 2012 at 14:18
Interest-only mortgages in which homebuyers simply service the interest on their home loan but do not repay the capital are in the dog house with the regulator.
A report by the Financial Services Authority (FSA) earlier this year found there were 3.9 million interest-only mortgages in existence. Worryingly, around three quarters of borrowers with such loans had no repayment plan in place.
The FSA considered banning interest-only mortgages but pulled back as lenders, such as Royal Bank of Scotland, NatWest, Coventry building society and Co-operative Bank, withdrew from the market over fears these loans had contributed to the credit bubble and left borrowers dangerously over exposed.
Interest-only loans are obviously cheaper than conventional repayment mortgages, where borrowers repay a bit of capital and interest each month.
In the days before the financial crisis interest-only mortgages were two-a-penny. Times were good and many people thought they could rely on rising house prices to repay their debt.
Today, after significant house price falls in many parts of the country, many homeowners have been left in a mortgage limbo. Unable to move because their homes are worth less than the loans they borrowed to buy them, they are also barred from switching to a new morrgage because lenders now have stricter lending criteria.
Despite their problems, interest-only mortgages are still available from a few lenders.
David Hollingworth of mortgage broker London & County said lenders were looking more closely at borrowers' income and were a lot tougher on the repayment schemes they would accept.
For example, lenders will no longer take the prospect of a borrower inheriting a lot of money as a repayment method. There is no certainty over when someone will die or what they have put in their will.
Neither will they lend to someone with erratic earnings who promises to make irregular overpayments on the loan when they have income. 'Overpayments aren’t acceptable because they are ad hoc and not a regular commitment,’ said Hollingworth.
The same applies to cash savings. A large sum of cash in the bank used to be enough to satisfy a lender that you could repay your mortgage, but not anymore. Cash savings are seen as too easily accessible and may be spent on other things than the mortgage.
Although relying on rising house prices sounds speclative, a small number of lenders are still prepared to lend to borrowers who plan to repay their mortgages with the sale of the property. But their terms are tougher than before. ‘If they are [willing to lend] then they want [the homeowner to have] a low loan-to-value and a minimum amount of equity of around £100,000 to £150,000,’ said Hollingworth.
At the end of the day, there is no beating having a regular investment plan in place if you want to get an interest-only mortgage. The idea is that the money you invest grows to a sufficiently large sum that will pay off the loan.
Amazingly, endowment savings plans from insurance companies are accepted by most lenders, despite the huge controversy over their performance a few years ago.
A more usual investment plan would be a stocks and shares ISA. Hollingworth says: ‘If you want to use an equity ISA lenders want you to have £50,000 in it to start with and then they calculate 80% of that as adequate to support loans but will not take into account future contributions or growth [of the ISA investments],’ said Hollingworth.
‘If you have less than £50,000 you may carry on paying in and hoping for growth but those future contributions and possible growth won’t count towards the total,’ he said.
More about this:
More from us
- Interest-only mortgages: why the government is on the hook
- Interest-only mortgages: what will lenders do?
- Q&A: why are banks clamping down on interest-only mortgages?
- Crunch will drive demand for interest-only mortgages, mform says
- Should interest-only homebuyers be made to switch?
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