Much has been made in the press over the last few weeks about the so-called ‘Interest-Only Timebomb’, a reference to the Financial Services Authority expressing concern about interest-only mortgages that are due to mature in the next few years. Of the 11.2 million mortgages currently held in the UK approximately 35% are interest only loans. 1.3 million of these mortgages are due to mature in the next 8 years and the FSA estimates that 80% of these borrowers have no final payment plan in place. To make matters worse, 320,000 of these mortgages are current under forbearance, meaning that the borrower has had some difficulty making payments and the lender has taken measures to help prevent them defaulting by changing the terms of the mortgage eg by switching on to an interest-only loan or by extending the term.
Interest-only mortgages started to become popular in the 1970’s and there was a huge increase in these loans in the 1980’s and 90’s, the main attraction being the lower monthly payments in comparison with a capital repayment mortgage. With an interest-only mortgage the borrower’s monthly payments only cover the interest on the loan, meaning that they are not paying back a penny of the actual loan itself (the capital debt). The full amount of the loan is payable at the end of the mortgage term, typically 25 years, and traditionally this was provided for by the borrower taking out an endowment policy, a type of savings plan linked to the stock market. The problem now is that the performance of many endowment policies has been very poor in comparison to forecasts. Also, by 2000, many interest-only mortgages were being sold without endowment policies as property prices were rising rapidly by then and borrowers were relying on the increase in equity alone to allow them to pay off the loan at the end of the term.
Many borrowers now find themselves in a very uncomfortable position. As they approach retirement age with the end of their mortgage term in sight they may be able to pay off the loan only by selling their home, and may not have enough left in reserve either to buy again and downsize or to pay rent and live comfortably during retirement. Options in this situation may be limited, with remortgaging more difficult when approaching retirement. Lenders may allow a change onto a capital repayment mortgage over a shorter term but this will usually result in a sharp rise in monthly repayments.
Interest-only borrowers with much longer to run on their mortgage term would be well advised to take a good look at their finances now. Think about how you intend to pay off the debt at the end of the term. If you don’t feel confident that you have a reliable savings plan in place, now may the time to think about remortgaging onto a capital repayment mortgage. Although you can expect your monthly repayments to rise by doing this (typically by up to 30%), lenders are currently offering some attractive rates on fixed rate deals and it is well worth asking an independent mortgage broker to look around the market for you. There may also be some room for negotiation with lenders here, for example they may be willing to limit the increase in monthly payments when remortgaging by extending the term of the loan.
Over the last few years since the housing market crash, mortgage lenders have tightly restricted the availability of interest-only mortgages. However, there are some borrowers for whom this type of loan is very suitable, for example a self employed borrower who may struggle to demonstrate a regular high income but does receive large amounts of income at irregular intervals. In this case taking out an interest only mortgage with lower monthly payments but then making occasional capital repayments to reduce the loan would be a good plan. Anyone wishing to take out an interest only mortgage will need a deposit of 25-50%, an excellent credit rating and a higher than average income.