Guide to Interest-only Mortgages

While only 13% first-time buyers took out an interest-only mortgage in 2003, this figure has risen to 18%. This increase is because that an interest-only home mortgage is the only way many first-time buyers can afford to purchase their own home.

A borrower who takes out a £100,000 mortgage fixed at 4.99% for three years pays around £590 a month for a repayment loan. But change this to an interest-only loan and the monthly repayment would be just £415.

The problem with interest-only mortgages is that unless you have a way of paying off the capital you have borrowed, you will have the same amount of debt at the end of the term as you started with.

At one time, lenders insisted that borrowers prove that they had some way to repay their mortgage - but this practice died out years ago. Now most lenders merely add a reminder on the bottom of the annual mortgage statement, warning that the borrower needs some means by which to repay the capital.

Interest-only borrowers are supposed to have an investment, such as an endowment or Independent Savings Account (ISA), to repay capital at the end of the term.

But three million homeowners are not making provision, instead rashly counting on rising house prices to give them a stake in their homes.

These borrowers face a crisis if house prices stagnate or fall because they will have done nothing to mitigate any negative equity. Even if prices continue to rise, they may endure a problem already facing millions with failing mortgage endowments: loans running into thousands of pounds that have to be paid off upon retirement.

The Financial Services Authority,which regulates all financial services in the UK, says it is a homeowner's responsibility to ensure that their loan can be repaid at the end of a mortgage term.

The managing director of mortgage broker Mortgageforce, Rob Clifford, says: “If after three or five years you are still not considering how to repay the capital part of your loan, then you are playing a very dangerous game”.

In a low inflation environment, mortgage debt is eroded slowly, and the rate of wage increases is low. With falling house prices, people won't necessarily have equity to cushion them. This means it is doubly important that homeowners think about how they will repay the capital.

Another important note for those thinking of taking out an interest-only mortgage is that over the long term, they are more expensive than repayment deals.

Mortgage broker, Purely Mortgages, points out that a £150,000 repayment mortgage over 25 years, with a standard variable rate of 6.75%, would cost £310,910 in capital and interest. But an interest-only deal under the same terms would cost £403,125 – interest of £253,125, plus the original loan of £150,000.

How can you pay off your loan?

The only one sure-fire way to clear your mortgage is to have a repayment mortgage, where part of each monthly payment goes towards reducing your debt. This costs more per month than an interest-only mortgage, but it need not cost that much more. Many people are paying far too much interest on their mortgages, and could benefit by swapping to cheaper deals.

Other possibilities for those on interest-only deals are:

• Switch part of the mortgage to a repayment.
• Start monthly saving into a cash mini ISA. Putting away just £50 a month for five years would produce a tax-free lump sum of around £3,480.