Is the interest-only mortgage endangered?

They have helped probably millions of people on to the housing ladder during the past two decades. But could low-cost "interest-only" mortgages be heading for the chop?

This week, the Financial Services Authority officially branded interest-only home loans as "high-risk", lumping them in with so-called liar loans and mortgages for people with dodgy credit records.

The FSA has also proposed that, in future, people applying for an interest-only deal would have to show they could in theory afford a more costly repayment mortgage. Bearing in mind that a repayment home loan can easily cost £300 a month more than an interest-only one, it is highly likely many wannabe homebuyers would fail this test.

The proposed clampdown could also spell bad news for some of those who already have this type of deal. What's more, when they come to remortgage, borrowers will find that lenders will be required to make more rigorous affordability checks, scrutinising their spending on everything from bills to booze.

In recent years, more and more people have turned to interest-only loans as a way of affording high property prices. With these, although you pay the interest, you don't pay off any of the capital debt, and it is up to you to set up a repayment vehicle – traditionally an endowment policy – to repay the loan at the end of the term.

It's not hard to see the appeal of these deals. Someone who today takes out a £150,000 mortgage fixed at 3.69% for two years with a 25-year term would have to pay £766 a month on a repayment basis, or £461 a month on an interest-only basis.

Around 30% of all home loans taken out between April last year and March this year – a total of 358,000 – were interest-only, and it is claimed that as many as five million people have this type of mortgage.

But the FSA has been worried for a while that many homebuyers who take out these mortgages could be storing up problems for the future, because they have little or no idea how they will pay back the loan. Some could be left with a huge bill when the loan matures in perhaps 20 or 25 years. If they can't pay it off, they could end up being repossessed.

The regulator says banks and building societies with higher numbers of interest-only customers tend to have more problems with people falling behind with their monthly payments. It adds it is aware that some borrowers are opting for these deals purely because they can't afford a repayment mortgage. It has therefore put them into the "high-risk" product category, but it is not banning them. Instead, it proposes that lenders will have to assess whether or not someone can afford an interest-only home loan by using the figures for an equivalent repayment mortgage.

"Interest-only mortgages are attractive to those on tight budgets because monthly payments are lower," says Melanie Bien at broker Savills Private Finance. "But they are riskier than repayment deals, particularly if you don't have an investment plan in place to clear the capital at the end of the loan. Those with interest-only mortgages are already finding tougher questions are being asked by lenders as to how they intend to pay back the capital."

Those borrowing less than 75% of a property's value will probably find it just as easy to get this type of mortgage as a repayment deal, though they may be quizzed about how they intend to pay off the loan. But above 75%, lenders are far more cautious. For example, Royal Bank of Scotland says its maximum loan-to-value (LTV) for customers wishing to pay their mortgage on an interest-only basis is 75%. Abbey announced last year that interest-only borrowers with "a proven repayment vehicle in place" would be able to borrow up to 75% – down from 85% – with those unable to produce evidence of a repayment vehicle limited to 50%.

What about those already on an interest-only mortgage? They will have no problem moving on to their lender's standard variable rate at the end of their initial period, says Bien, but remortgaging to a fixed or discounted rate could be more tricky. "If they are moving to a deal offered by their lender and have a high LTV, the lender may insist they switch part or all of the loan on to a repayment basis. If they want to remortgage to another lender, this will be even more difficult, as they will have to go through an affordability check, and the interest-only nature of the loan is likely to make the lender wary. This could mean borrowers have no option but to stick with their existing lender on the SVR – fine, perhaps, when interest rates are low, but not so attractive should rates rise and payments become more expensive."

So, if you have one of these deals, start thinking now about how you are going to pay off the loan.



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