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Interest only mortgages - Susan Taylor, Taylor Carmichael

Are interest only mortgages bad for your health?

One of the main factors which contributed to the rise in house prices over the last decade was the interest only mortgage.

As borrowers stretched to compete in the rising market and purchase their ideal home, many then overstretched themselves and the only way to purchase their ideal property was by taking the mortgage on an interest only basis.

This helped first time buyers get on the property ladder and meant that buying a property was cheaper than renting, even if using hindsight we can now look back and realise that a high proportion of purchasers perhaps paid too much for their ideal home. For every £1,000 extra they spent on buying their home, this resulted in an average of around an extra £4 per month on their interest only mortgage. It’s easy to see why therefore you could easily offer an additional £10,000 to secure a property if it only meant an extra £40 per month on your mortgage, and easy to see therefore why house prices were rising at such unprecedented levels.

However as we have witnessed in recent months when property values drop, borrowers with interest only mortgages are faced with a property which has reduced in value but a mortgage debt which has remained the same. This has resulted in a negative equity scenario for many people who bought properties at the peak of their values in 2006/2007.

Many of these borrowers are now stuck in a situation where they cannot sell their property and at the same time cannot remortgage to a different lender. In particular those who took advantage of Northern Rock style mortgages, where you could borrow up to 125% of the value of your property on an interest only basis, are locked in with Northern Rock on their standard variable rate.

The standard variable rate is of course acceptable while interest rates are low, but what will happen when interest rates start to rise again? The only option open to these borrowers in the meantime is to overpay as much as they can afford to on their mortgage while interest rates are low, and hope in the meantime that their property value will start to increase once more. Hopefully this will allow them to get their borrowing back below 90% of the value of their property and provide more choice of mortgage options within the marketplace.

We can therefore understand why one of the main changes taking place in the mortgage market at present is the withdrawal of interest only mortgages from many lenders. The Financial Services Authority are prioritising this area of the market and buyers cannot now simply request an interest only mortgage just because it is the only means by which they can buy a certain property.

Lenders who do still offer an interest only mortgage option will now typically limit the borrowing to 75% of the value of the property, which will go some way towards reducing the risk of a negative equity situation in the future. In addition to this some lenders are now even pricing products differently between a traditional capital & interest repayment mortgage and an interest only mortgage.

As interest only mortgages are being deemed higher risk, lenders such as Halifax and Lloyds TSB are charging a higher interest rate if you want to select this type of mortgage, with a 0.2% loading being typical.

In addition to this borrowers must have a specific and realistic plan in place to repay their interest only mortgage which can be demonstrated to the lender, for example lump sum overpayments from bonuses, sale of other properties.

So should interest only mortgages carry a government health warning?

The FSA certainly seems to be moving towards excluding “interest only” mortgages from the options available to consumers. Lenders are restricting the loan to value they will offer, with higher interest rates being applied in some cases.

In reality however as the marketplace evolves, is there still a place in the UK market for interest only mortgages?

The answer is yes, there is still a need for interest only mortgage options, as long as borrowers understand the risks of such an approach to their mortgage, and the adviser has carefully analysed their ability to repay the debt.

Many people who work in an environment where they earn a basic salary but have the opportunity to earn an annual lump sum bonus, may prefer the flexibility of an interest only mortgage and the ability to repay the debt via an annual one off overpayment to their mortgage rather than having the commitment of making a larger payment each month.

This type of proposal may also suit a self employed borrower who has a seasonal aspect to their income and again would prefer a small monthly payment throughout the year with the ability to make lump sum payments when it suits them to reduce the debt.

In addition to this some borrowers do still contribute to endowment policies which although they might not pay off as much as they had hoped on maturity, they will still provide a lump sum to repay a proportion of the borrowing. Other borrowers may have ISAs or other investments which they plan to use to repay the debt.

Critically, however borrowers on an interest only mortgage do need to show some discipline in their approach and continually review the situation to check they are still on target to repay their mortgage within the term they had planned. If they are not, then consideration should be given to switching either some or all of the debt to a capital & interest repayment basis.

So whilst it makes sense for this area of the mortgage market to become more tightly regulated and to restrict the availability of interest only mortgages, there is still a place for this type of lending so long as borrowers fully understand the risks involved. Quality independent advice can assist borrowers in making an informed decision on what is best for their individual circumstances.

Susan Taylor

Susan Taylor has been providing independent mortgage advice within the UK marketplace for over 12 years. Passionate about sport and travel, she recently co- launched Taylor Carmichael Financial Services providing bespoke mortgage advice to a broad spectrum of UK wide clients.

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