The pros and cons of interest-only mortgages

POSTED: 15th July 2013
IN: Personal Guides

An estimated 4 million people have interest-only mortgages in the UK, many of which were advanced before the onset of the financial crisis and subsequent credit crunch that led to the demise of 100 per cent mortgages and interest-only mortgages as lenders tightened their lending criteria.

undefinedThis represents a major headache for some people who want to take advantage of low re-mortgage rates but find they are not accepted for the best mortgage deals as they have not repaid any of the capital they borrowed and are unable to put a deposit down to qualify for the best deals.

What is an interest-only mortgage?

With an interest-only mortgage, the borrower only needs to repay the interest element on the amount they have borrowed. The capital is repayable at the end of the mortgage term, usually 25 years.

This means borrowers need to have a plan in place to repay the principal sum at the end of the term.

In the 1980’s and 1990’s interest-only mortgages were often linked to endowment policies where money was saved into an endowment to be used to pay of the capital at the end of the term.

However, these were often sold to people as offering the best of all worlds, where borrowers would be able to use money from their endowment policies for extra’s such as holidays and home improvements, safe in the knowledge that the capital appreciation of the policy would be enough to cover the repayment at the end of the term.

Though this can and did work for some people, many people did not have enough saved in their endowment policies at the end of the term to pay off the capital.

The demise of interest-only mortgages

As the repercussions of the financial crisis reverberated around the global economy and the full consequences of US sub-prime mortgage lending became clear, lenders moved away from 95 per cent and 100 per cent loans for mortgages as well as lending on an interest-only basis.

However, Bank of England statistics show that during 2005 and 2006 40 per cent of mortgage loans were advanced on an interest-only basis. The Financial Conduct Authority (FCA) estimates that 2.6 million interest-only mortgages will mature between now and 2041, with around 600,000 maturing before 2020 and warns that many borrowers have not made any provision to save the capital sum needed to pay off the balance at maturity.

In May 2013, the FCA published its review into the interest-only mortgage market. It concluded that half of the people who have an interest-only mortgage that is set to mature by 2041, 1.3 million people, may not have enough funds to pay off the capital balance when it matures. The FCA said the average shortfall would be £71,000.

By 2011, according to the Council of Mortgage Lenders, the percentage of all new mortgages that were interest-only was just four per cent.

However, as the economy emerges from recession, and lending to first-time buyers increases, interest-only mortgages are making a comeback as more of a niche product.

This presents an opportunity for some banks to carve out a position and reputation for themselves in the market.

Benefits of interest-only mortgages

If they are lent to responsible borrowers and managed effectively with a repayment plan in place, interest-only mortgages are suitable for people who have irregular income such as the self-employed and people who earn a lot of their income through commission and bonuses.

Interest-only mortgages often allow extra flexibility to make lump-sum repayments, reducing the capital balance, which suits certain types of borrowers.

Currently, if you have an interest-only mortgage which you took out on generous terms as a lifetime deal tracking the Bank of England base rate before rates were dropped to the record low level of 0.50 per cent in March 2009, you are likely to be benefitting from very small repayments.

During a period of rising house prices and high interest rates, you benefit from lower monthly repayments with the rise in house prices taking care of much of the money you have to repay at the end of the term, though of course you have to be prepared to sell your house and downsize or withdraw equity to do so.

If you held an interest-only mortgage for a number of years before the financial crash, while house prices were rising consistently for 10 years between 1997 and 2007, the chances are that you have built up enough equity to be able to repay the capital.

Disadvantages of interest-only mortgages

In the run up to the credit crunch, some banks were guilty of extending too much credit, often to inappropriate borrowers and individuals were too reliant on rising house prices as a way of repaying capital.

However, the issue becomes more of a problem for borrowers who were advanced large loans on an interest-only basis at or just before the height of the financial crisis, those 40 per cent of new homeowners from 2005 and 2006.

Average house prices fell by more than 10 per cent between 2007 and 2009 and in some parts of the UK by more. This means some borrowers would be in negative equity with no repayment vehicle in place.

For these people, the silver lining is that they have a longer term in which to raise their own income levels and switch to a repayment mortgage and also take advantage of future house price rises.

Another disadvantage is that by not paying down the capital you have borrowed it is more difficult to qualify for the best mortgage deals. As many lenders have introduced tighter criteria, those with existing Interest Only mortgages are also finding it increasingly difficult to secure a new mortgage if they wish to take our additional borrowing or are moving home.

In conclusion, there is a place for interest-only mortgages in the market as long as a suitable repayment plan is in place.

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