Regulations Tighten On Interest Only Mortgages

Interest-Only Mortgages: Risks and Considerations

Popularity and Savings:

Interest-only mortgages are popular due to their lower monthly payments compared to repayment mortgages. For instance, a £125,000 interest-only mortgage at a 5% interest rate costs £525 per month, while a repayment mortgage at the same rate costs £735 per month. This lower monthly cost appeals particularly to first-time buyers and those on tight budgets.

The Risk of No Repayment Plan:

Despite the lower payments, a significant concern is that 37% of homeowners with interest-only mortgages do not save any money towards repaying the principal at the end of the mortgage term. This poses a risk if they cannot repay the mortgage capital as planned.

Regulatory Changes:

In response to these concerns, the Financial Services Authority (FSA) introduced new rules requiring lenders to verify that borrowers have a solid plan for repaying the mortgage capital. Borrowers must provide evidence of a verifiable repayment vehicle, such as:

- Personal Equity Plan (PEP)

- Individual Savings Account (ISA)

- 25% tax-free cash from a Personal Pension Plan (PPP)

Lenders are required to ensure these plans are in place and realistic. Simply stating intentions is no longer sufficient.

Lender-Specific Rules:

Different lenders interpret the FSA’s rules in various ways. For example:

- Nationwide Building Society: Does not approve interest-only mortgages if repayment is planned through inheritance or future pay rises. They require a significant amount of net equity and a lower loan-to-value ratio.

- General Advice: Many mortgage advisers suggest using interest-only mortgages only as a last resort. They recommend repayment mortgages to avoid the risk of insufficient investment returns.

Alternative Approach:

Some advisers support interest-only mortgages as a temporary solution, advising borrowers to switch to a repayment mortgage after a few years. Advisers often recommend choosing a mortgage that allows penalty-free overpayments, enabling borrowers to reduce the principal whenever possible.

Key Takeaways:

1. Be Aware of the Risks: Interest-only mortgages can be risky without a concrete repayment plan.

2. Verify Your Plan: Ensure that your repayment vehicle is solid and verifiable.

3. Explore Alternatives: Consider a repayment mortgage or a flexible interest-only mortgage that allows additional repayments.

4. Consult Advisers: Seek advice to ensure that any mortgage recommendation aligns with your financial situation and goals.

Interest-only mortgages can be useful under specific circumstances but require careful planning and verification to avoid potential pitfalls.