Taking an interest
In light of the current market conditions, might interest-only mortgages be the answer for pressed borrowers? Barney McCarthy finds out
The plight of the first-time buyer has worsened over the last six months. Getting onto the property ladder was difficult enough with soaring property prices presenting a fearsome hurdle, but the credit crunch has made things even tougher. While the rate of house price growth has slowed somewhat giving the appearance that the situation may be mellowing, the credit crunch has led to lenders tightening their criteria (see the May issue of Your Mortgage, on sale 17 April to find out more) and even withdrawing products.
With all this conspiring against them, you wouldn’t blame first-time buyers for giving up their aspirations of homeownership. But there are still a number of ways to ease the burden and obtain a mortgage. Interest-only mortgages reduce a borrower’s monthly repayments as they are only paying the interest on the mortgage, rather than a small portion of their mortgage in addition to the interest. While interest-only mortgages can be a useful way of alleviating the financial strain at the outset of home ownership, it should not be viewed as a long-term solution as you are not actually making any headway in paying your homeloan back.
It used to be the case that interest-only mortgages were coupled with endowment policies, but lenders do not require a stipulated payment method. This isn’t to say you shouldn’t have one though, and lenders should ensure that the customer is fully aware of the implications of taking out an interest-only mortgage and of not being able to repay the loan.
Approach with caution
Vicki O’Connell, spokesperson for Chelsea Building Society, says a rise in property prices and affordability issues have seen the popularity of interest-only mortgages soar, but warns that choosing one is still a decision that needs to be carefully thought through. “Many people presume they can rely on a rise in their property’s value or expected inheritance to repay their mortgage, but this could be a risky gamble,” she says. “A decline in the housing market could mean a very different return to the one expected and inheritance shouldn’t be relied upon either, especially with the increasing trend of equity release mortgages for the older generation, which will ultimately mean a diminishing inheritance pot.”
O’Connell adds that some borrowers take out a combination of interest only and repayment methods so at least some of the loan is decreasing, while others convert a percentage of their interest-only loan to repayment a year or two into the mortgage term and continue to do so every few years thereafter as their income grows.
Sue Read, associate at Birmingham-based brokerage Moneywatch Finance, says that she adopts a cautious approach when advising on interest-only mortgages. “If borrowers take out interest-only mortgages, I stress that they should put any spare cash into a savings pot such as an ISA or use it to overpay the mortgage,” she says. “This would build up a contingency fund so that if times become hard they have some accessible funds to fall back on. If anything I over-emphasise the dangers of the interest-only route as it does concern me that in 20 years or so we will see a whole pile of mortgages coming up for repayment and no vehicle in place.”
The hard facts
The Your Mortgage website has mortgage comparison calculators where you can compute your monthly repayments and total interest owed by entering your loan amount, interest rate and mortgage term, and compare the results for a conventional repayment method with that for interest-only. Taking the average house price in the UK at present – £180,000 – and the average interest rate paid in January according to the Council of Mortgage Lenders – 6% - and calculating the interest due over 25 years (a conventional mortgage term) makes for some eye-watering results.
Borrowers on a repayment mortgage will have to pay £1,159 a month on a £180,000 mortgage and will end up owing £167,922 in interest. Those on interest-only mortgages will have to pay only £900 a month to their mortgage lender, but will end up paying a whopping £269,999 in interest by the end of the term. Although this is an extreme example as interest-only mortgages are only really intended as a short-term solution, it shows how much more you will end up owing in the long run.
Interest-only mortgages can provide a valuable leg-up onto the property ladder, but should really only be regarded as a short-term option. Rely on them too heavily, and you could end up dangling dangerously from said ladder.
