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Are interest-only mortgages a time bomb? By Rob Griffin
The Financial Services Authority (FSA) has launched an investigation into interest-only mortgages amid concerns that borrowers have no idea how they will repay the capital sum. The regulator is alarmed at the number of products sold by lenders The industry fears that many people either do not understand how interest-only products work or simply will not put enough money aside throughout their lives to avoid a long-term financial crisis. Failing to do so could mean they have to sell their homes when they reach their fifties and sixties - or even have their homes repossessed. Paying out less The most popular way to buy a house is with capital and interest mortgages - over 70% of first-time buyers and over 60% of existing homeowners chose them in 2005. The monthly repayments cover the interest and help reduce the capital sum. However, thousands of people opt for interest-only mortgages where repayments will only cover the interest on the 'loan' they have taken out to buy the property. Although these borrowers will be paying out a lot less each month than they would for a capital and interest product, they will still owe the original amount that they borrowed when the term of their mortgage comes to an end. At this stage, they will need to have a lump sum available to pay the remaining mortgage back in one go. Failure to do so could mean they end up losing their home and all the payments they have made will have been for nothing. Repayment plan To avoid this scenario, borrowers need to make sure they have a repayment plan which will allow them to build up the required sum; as interest from bank and building society accounts is so miserly, this will often mean a stockmarket-based investment. Keeping a close eye on the savings plan is essential to make sure there won't be a huge shortfall in future years. Despite the long-term risks, figures compiled by the Council of Mortgage Lenders reveal that these products are growing in popularity, both among existing homeowners and first-time buyers who have been struggling to afford repayments due to rising house prices. Almost one-in-four people who moved home last year opted for an interest-only product without specifying whether they had any linked savings plan, such as an individual savings account (ISA), in place to clear the debt at the end of the term. First-time buyers Perhaps more worrying is the number of first-time buyers choosing to go down this route. So far in 2006, 23,200 interest-only mortgages have been sold to first-time buyers and 55,200 to existing homeowners where the lenders have not recorded how these borrowers planned to pay off the capital. These figures have led some industry observers to dub interest-only mortgages as the "next financial scandal". But it is only when people realise they have a shortfall that alarm bells will start ringing. The Financial Ombudsman Service, which helps resolve disputes between consumers and the providers, says that only a few hundred out of almost 4,000 complaints received each year about mortgages relate to interest-only products. However, Ray Boulger, senior technical manager at mortgage broker John Charcol, believes interest-only products can work very well - as long as people appreciate exactly how they work. "The key thing is that people understand what they are doing and realise they have got to pay that capital back at some stage," he explains. Suitable candidates So who is suitable for interest-only? The first group of people who may be attracted to interest-only are the self-employed whose monthly income tends to vary. "It may make a lot of sense for them to effectively make capital repayments as and when it suits them," says Boulger. Young professionals who are in a job where they can anticipate their salaries rising quite sharply over the next couple of years could be tempted to stretch themselves and buy a house via an interest-only product. Once their income has gone up, they can then pay into some kind of repayment vehicle, making overpayments to their mortgage or switching to a capital and repayment mortgage. Keeping the initial repayments down by going interest-only may enable them to afford a property that would otherwise have been out of their reach. Those buying second homes may also opt for interest-only. This could particularly be the case if they plan to sell one property when they retire, as there will not be the need to repay both before stopping work. "But if the only way you can actually afford to buy a property is to have it interest-only - over the long term - then it won't be suitable," says Boulger. "The only way you're going to be able to repay the mortgage is to sell your property, unless you have a windfall." Mortgage comparison The Lifetime Tracker product from Hinckley & Rugby Building Society and the respective costs involved in borrowing £150,000 over 25 years between the two product types. Under the capital and interest method - presuming an interest rate of 4.75% - a borrower would be paying £855.18 every month. At the end of the term they will have paid £259,450.73 with no debt outstanding. If they had plumped for interest-only, their monthly repayments would have been just £593.75. This means they would have paid out £181,023 after 25 years, yet they would still have the £150,000 lump sum to find at that point. They will have spent a grand total of £331,023 on their property by going interest-only, which means they will have paid out £71,572.27 more for their home than a similar person on the capital and interest version. Stop and think Anyone who finds interest-only products appealing needs to think long and hard before taking the plunge. While the prospect of paying relatively low amounts each month can seem very enticing, failure to pay close attention to how they plan to pay the cash back means they are effectively placing a time bomb under their finances.
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