The decline of interest-only mortgages
By Kate Saines
Interest-only mortgages are a contentious product. While they might appear to be the solution to affordability hurdles many homeowners and first-time buyers might encounter, they can also land borrowers in a financial mess.
After enjoying a surge in popularity several years ago, lenders are now reluctant to supply interest-only mortgages.
If you are looking for an interest-only remortgage, for example, and have a loan-to-value (LTV) of 75 per cent or less, you'll be far more likely to be approved than a first-time buyer with a five per cent deposit.
So what's the story with interest-only mortgages? Are they still a viable option and how can we get the best out of them without disadvantaging ourselves? Here's the lowdown.
What are interest-only mortgages?
As the name might suggest, this is a mortgage where the borrower only repays the interest on the loan.
Unlike repayment mortgages, where borrowers repay the interest and some of the capital each month, interest-only customers do not pay back any of the loan until the end of the term.
In order to pay it off at the end of the term, borrowers put additional funds into investments – like endowment policies, ISAs or pensions – which will mature to provide this final payment.
Most lenders offering interest-only mortgages will ask for a suitable repayment plan to be in place before they will agree to provide the loan.
Should you decide to remortgage, and come off the interest-only deal, your investment will be injected into your new mortgage.
Who are interest-only mortgages for?
While there is no specific person who fits the criteria of an interest-only mortgage borrower, up until recently they were very popular with first-time buyers.
Neil Baker, an IFA at Protection and Investment Ltd, said: "Originally a lot of people took them out to get onto the property ladder.
"This is because interest-only kept your costs down, but a lot of people did not have any repayment plans in place."
In fact, Mr Baker explained, demand for interest-only mortgages hit its peak just before the credit crunch when few lenders were asking questions about how borrowers were going to repay the mortgages.
All this changed last year, according to Mr Baker, and now lenders are less keen to offer interest-only options and have increased their demands on borrowers accordingly.
Anyone with less than a 75 per cent LTV is now unlikely to get a deal on an interest-only mortgage.
Mr Baker said these days most of his clients who opt for interest-only are older people, nearing retirement, who plan to downsize to a smaller less expensive property when they give up work.
Families with young children who may be struggling with budgets are also more likely to take out interest-only mortgages in a bid to keep their costs down for a few years.
And Mr Baker said he also finds people who like to dabble in investments are also keen to choose the interest-only option.
He also recommends interest-only to buy-to-let investors because having a mortgage on a property that is rented out has tax advantages.
Read more: First-time buyers guide to home-buying and mortgages
What are the advantages?
The main advantage is the lower monthly cost. Also, interest-only mortgages provide a little more flexibility because some mortgage companies will allow you to make overpayments of around ten per cent.
And what about the disadvantages?
The main pitfall with an interest-only mortgage is the fact you never really know if you are going to be able to repay it at the end of the term.
Although most mortgage companies are now asking to see details of repayment plans, in the past few were concerned with this. As a result many borrowers are on interest-only mortgages but have no repayment system in place.
What's more, even if you have a repayment scheme there's no guarantee you'll have enough to fully repay the loan at the end. This could leave you with a shortfall, and you will then end up having to find the funds to repay the loan elsewhere.
Neil Baker also pointed out that taking out an interest-only mortgage will also mean you'll end up paying more interest over the course of the mortgage.
Is there still a place for interest-only mortgages?
According to the statistics, fewer interest-only mortgages are being taken out and numbers are tumbling all the time.
Figures released just last week by the Council of Mortgage Lenders (CML) show a shift away from interest-only since 2007, particularly from first-time buyers.
The CML said that prior to the financial crisis it was typical for around 30 per cent of loans to first-time buyers to be interest only. But, in March 2011, only four per cent of first-time buyers were choosing this option.
This is mainly down to the fact that fewer lenders are offering the products.
John Heron, managing director of Paragon Mortgages which also unveiled figures showing interest-only figures plunging, said residential mortgage lenders had been clamping down on the products since the start of the credit crunch.
"The decline of this market," he said, "shows no sign of slowing down. The Financial Services Authority (FSA) signalled the demise of interest-only through changes proposed in the Mortgage Market Review and it appears that lenders are positioning their businesses in anticipation of regulatory changes."
But while it might appear there is no future for the controversial products, Neil Baker of Protection and Investment Ltd thinks there will always be a need. And the FSA also denied it had called for a ban of interest-only mortgages.
Mr Baker said: "There's always going to be an advantage to interest-only mortgages for some borrowers, so they will not disappear."
But he thinks their take-up depends on the lenders and their criteria.
There's still flexibility in 75 per cent LTVs for many borrowers but if lenders start going down to 60 per cent LTV there will not be much of a market, he said.
Still interested in interest-only?
If you think you'll fit the criteria and are still keen to take out an interest-only mortgage, Mr Baker said its imperative you speak to a mortgage adviser.
"It's important to have a repayment plan in place and an adviser will be able to assist you with this," he explained.
It is also advisable to ensure you regularly check on your repayment scheme to ensure it is maturing and is healthy enough to provide that all important final payment.
Use the Myfinances.co.uk comparison tables to find the best deal on a new mortgage.
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