In the wake of the financial crisis, the provision of – and demand for – interest only mortgages plummeted. By 2012, only 12 lenders still offered this type of mortgage. However, in the third quarter of 2017, the number of interest only mortgages had risen by 45% to reach a total value of £5.4 billion, and they are now offered by 33 different lenders. We explore this niche financial product with a consideration of:
- The pros and cons of interest only mortgages
- The reasons for the increase in interest only mortgages
- competition among lenders
- borrowers switching to a lifetime mortgage
In this article, we explain the attraction of interest only mortgages, and why there has been a surge in their popularity. In weighing up their pros and cons, we look at the history of these financial products. What problems are interest only mortgage holders facing now as their loan term comes to an end?
The pros and cons of interest only mortgages
One of the reasons why interest only mortgages appealed to people in the past is that their monthly repayments were considerably lower. As they were only paying off the interest – rather than making inroads into the capital – they had much more disposable income. This financial product was marketed as a way to allow them to buy a house, and yet still have money left over to spend on cars, foreign holidays, etc.
Before 2014, many homebuyers chose this kind of mortgage as it gave them the opportunity to purchase property that they otherwise couldn’t have afforded. Instead of gradually starting at the bottom rung of the property ladder, their plan was that they would start with a family-sized home, and wouldn’t have all the extra expenses that repeated moves and house sales would entail.
Finally, interest only mortgages were very attractive for people who didn’t have a regular salary such as contractors, freelancers and the self-employed. Instead of having to make a set monthly repayment, such a mortgage gave them more flexibility with their repayments especially in months when their income dropped.
Although interest only mortgages involve lower monthly repayments, in the long-term people end up paying much more than they would with a capital repayment mortgage. As the capital isn’t paid off till the end of the loan term, interest fees remain high and add to the overall cost of the property purchase.
Another major problem with interest only mortgages is that borrowers are expected to come up with a repayment strategy. In other words, how would they come up with a lump sum at the end of the loan term to repay the entire purchase?
Possible ways to repay include endowment policies, savings or investment portfolios or the expectation of an inheritance. However, the problem is that many find that their repayment option doesn’t go to plan. For example, their investments underperform. In this case, they have no alternative way of paying off their interest only mortgage, and face the very real danger of having their home repossessed. Interest only mortgages may be deceptively cheap, but they are much riskier.
Interest only mortgage questions:
An interest only mortgage is a type of loan that allows you to only pay off the interest on the amount that you borrowed on a monthly basis, and not the capital amount. Consequently, the monthly payments would not pay off any of the loan amount but instead you would have to pay off the entire mortgage amount at the end of the borrowing term in a lump sum.
Interest only mortgages are not available to all borrowers. Certain criteria set by banks or other mortgage lenders are to ensure that the repayment of the capital amount can realistically be made at the end of the loan term. Specifically, the criteria normally regarding income requirements that are specified by individual lenders. A strategic repayment plan is put in place to ensure the successful repayment of the loan amount.
Interest only mortgages may seem like an attractive option for potential property buyers. However, they constitute a type of mortgage that is not designed for most borrowers. The primary concern with an interest only mortgage is that it enables a property buyer to proceed with a purchase that they may not realistically be able to afford. Once the payments are increased, due to fluctuating interest rates, the buyer may be unable to meet their financial obligations. In most cases, it is advised that potential property buyers select fixed rate loan products.
Why the recent increase in interest only mortgages?
The cases of borrowers having made no provision to pay off their interest only mortgage or being left with a shortfall is such a matter of concern for the FCA that they have called the matter “a ticking time-bomb”.
A major problem with interest only mortgages is that borrowers are expected to come up with a repayment strategy.
Bearing this in mind and the publicity of homeowners being threatened with eviction because they’ve been unable to pay off the capital on their home, why are the number of interest only mortgages on the rise? Shouldn’t people be more wary of such mortgages?
Less irresponsible lending?
The Mortgage Market Review put into effect stricter regulations about granting mortgages including robust affordability checks – rather than just concentrating on proof of income. With these checks in mind, lenders believe that interest only mortgages are less riskier than they once were. Some critics have accused them of not having learnt from the mistakes of the past, and that they have become complacent again about their lending decisions.
Competition among lenders
Just looking at the number of 0% credit card transfers will give you an idea of how cut-throat retail banking has become in recent years.
Financial institutions are constantly on the lookout for ways of inching ahead of their rivals by offering something new. Providing interest only mortgages as a niche product has been singled out as a way to get ahead.
Borrowers switching to lifetime mortgages
FCA research found that 1 in 9 of those with an interest only mortgage are now over 65. Many of those who have a short-fall in the money they need to pay off their mortgage would like to switch to a capital repayment mortgage. However, many lenders have age limits on such mortgages, or borrowers wouldn’t be able to afford repayments once they retire.
As a result, many have switched to a lifetime mortgage. This has been made easier since the FCA loosened their regulations. Lifetime mortgages are repaid when the property is sold – either on the death of the mortgage holder, or when they need long-term residential care because of illness or infirmity and have to move. This choice to switch to a lifetime mortgage has also inflated the numbers of interest only mortgages being granted recently.
Are interest only mortgages still risky?
It’s hoped that mortgage providers have learnt the lessons of the past, and are being stringent in their lending decisions when it comes to interest only mortgages.
As for borrowers, for certain groups of people an interest only mortgage makes financial sense considering their circumstances. However, it’s crucial that they consult a specialist so that they can weigh up the pros and cons of this type of mortgage. They also have to give a great deal of thought to their repayment strategy. If they don’t, it could end up costing them their house.