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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

The rise and fall of interest-only mortgages

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.

5 comments so far. Why not have your say?

Anonymous 1 needed this 'off the record'

Dec 14, 2012 at 15:45

And yet when I asked Barclays to arrange a woolwich mortgage using my guaranteed minimum return bonds with Barclays I was tolsd that the bonds were not 'safe' enough to be accepted at the guaranteed minimum as a repayment facility for the mortgage.

And for those not quite in the 'know' Barclays owned Woolwich.

So basically Woolwich were saying that the company that owned them could not be trusted to repay the bonds it had issued.

And for those of you who will be working past the age of 65, You'll probably find that when advised that you want the mortgage until you are 68, 69, 70, or 71 etc. then, as the list of organisations willing to lend gets smaller, the fees and rates get larger.

As in a 40 year mortgage for a 30 year old may 'attract' a 1% hike in the rate over that of a 30 year loan

40 years on £200K : 6% = £480K

30 years on £200K @ 5% = £300K

30 years saving the extra 1% = £60K

So those extra 10 years cost £120K

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John Lacy

Dec 14, 2012 at 15:58

The real killer on interest only mortgages (compared to repayment mortgages) is that as you pay the capital back at the end of the term you have been charged a considerable amount of extra interest because you haven't been reducing your debt as you go along. Just do identical quotes and see how much extra you pay on an interest only---if that doesn't put you off I would suggest that you may need medical attention!

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Anonymous 1 needed this 'off the record'

Dec 14, 2012 at 16:19

John,

You are making an enormous assumption - that the interest on the interest only mortgage is higher than on a repayment mortgage.

And you are making another enormous assumption - that the interest on the interest only mortgage is higher than you can get (after tax) on investing what you would have paid over as the 'repayment' part of the mortgage.

My mortgage is variable, but at a nice low premium over the BoE rate.

Consequently I can (currently) make enough to pay the interest for a couple of months a year from the after-tax interest I get (above the interest cost to the mortgage of having that additional amount outstanding) from an instant access savings account.

And I have the option to repay additional lump-sums when I wish so if the savings account rates go below the cost, I can just take the money from the savings account and pay off a substantial amount of the mortgage capital.

Yes - that cost me in fees when I setup the facility but I recovered the extra fees within 5 years from interest on the capital I held rather than paying off the capital of the mortgage.

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John Lacy

Dec 14, 2012 at 18:40

Anonymous---On a like for like basis at the same interest rate the total amount paid over the term on an interest only mortgage will always be higher than a repayment. I take your point about the low Tracker that you have at the moment as I'm in the same position paying a whole 0.17% over base rate.

As long as you have the cash to pay off the mortgage when you come to the end of the agreed term you will come to no harm----the problem is that not everyone is as prudent as you and a lot of the interest only mortgages out there will come to an end with the borrower approaching retirement and with no facility for paying off the debt. Usually the same people haven't bothered to make any pension arrangements so face a catastrophic drop in income just as they are being asked to refinance away from their interest only scenario.

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neXus 6

Dec 17, 2012 at 09:16

Ahh. Good old FSA. Horse bolted again after they left the door open for banks to lend to 120% loans to people with no income, no credit history and secured on BTLs that couldn't possibly fall in value, could they?

Now everyone has to repay his mortgage. Even those of us with the only secure income to pay the loan interest forever (pensions) in order that we can die and leave another 40% to HMRC.

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