Mortgages. Why Interest Only Can Be A Risky Option

The Rise and Risks of Interest Only Mortgages

Interest-only mortgages have seen a resurgence in popularity, with a noticeable increase in their usage from 9% of new mortgages in early 2002 to 23% by late 2005. Among first-time buyers, interest-only mortgages rose from 6% to 15% in the same period. This shift is largely driven by the lower monthly payments compared to repayment mortgages, which can make homeownership more affordable in the short term.

Understanding Interest Only Mortgages

How They Work:

• Monthly Payments: You only pay the interest on the loan each month. The capital (the amount borrowed) is repaid in full at the end of the mortgage term.

• Affordability: This setup helps borrowers maintain their current lifestyle without the immediate financial strain of higher monthly payments.

Risks and Concerns:

• Future Lump Sum: At the end of the mortgage term, a large lump sum is required to repay the capital. Without a sufficient savings plan, borrowers may face financial difficulties.

• Lack of Savings: Many people may not save enough or may cancel their savings plans after securing the mortgage, risking an inability to repay the capital.

Regulatory Changes and Lender Responses

FSA’s Concerns:

• Proof of Savings: The Financial Services Authority (FSA) now requires borrowers to demonstrate they have an alternative savings plan to cover the capital repayment. This is to prevent a repeat of past issues where endowment policies failed to meet their promises.

• Savings Vehicles: Common options for saving include pensions and ISAs, but they may not always meet the required amount by the end of the term.

Historical Context:

• Endowment Policies: In the past, endowment policies were used to cover the capital repayment but often underperformed, leading to shortfalls.

• Current Trends: The failure of endowment policies contributed to a shift away from interest-only mortgages. However, with rising house prices, interest-only mortgages are making a comeback.

Alternatives to Interest Only Mortgages

Extended Terms:

• Longer Mortgage Terms: Extending the mortgage term can reduce monthly payments. For example, a £125,000 mortgage at 4.9% over 25 years costs £731.69 per month, while extending it to 35 years reduces the payment to £628.16, saving £103.53 each month.

Flexible Options:

• Overpayments: Many mortgages allow for overpayments, which can reduce the term and total interest paid.

• Hybrid Mortgages: Some options involve repaying part of the capital each month and the remainder at the end of the term, offering a middle ground between interest-only and full repayment.

Professional Advice:

• Expert Guidance: Given the complexity of mortgage products and the potential financial implications, seeking advice from a mortgage professional is crucial. They can help assess various options and find the most suitable solution based on individual circumstances.

Summary

Interest-only mortgages are becoming more popular due to their lower monthly payments, but they come with significant risks, especially related to saving for the capital repayment. While they can be a viable option for some, it's essential to carefully consider alternative mortgage structures and seek professional advice to ensure financial stability and avoid future difficulties.