The Abbey says that more than 25% of people who own their homes pay for them with an interest-only mortgage. Their monthly payments are much lower, which makes sense. For example, a GBP125,000 interest-only mortgage with a 5% interest rate and a 25-year payback period costs GBP525 per month. However, if the mortgage is paid back, the monthly cost goes up by GBP210, to GBP735.
This level of saving money has been very popular with first-time buyers who are having trouble getting their feet on the property ladder and with people who have a tight monthly budget. But there's a ticking time bomb. 37 percent of homeowners with interest-only mortgages are not saving any money for when they have to pay back the mortgage capital at the end of the mortgage term.
The Financial Services Authority (FSA) is worried about this problem, so they put in place new rules last year that require lenders to ask new borrowers for proof of what steps they're taking to pay back the money. And it won't be enough for the borrower to say they plan to sell the house to pay off the mortgage. From now on, the FSA is likely to say that any new mortgage that is sold was mis-sold if the application doesn't include information about a way to pay back the mortgage that can be checked and is likely to bring in enough money to pay off the mortgage. And if the numbers don't make sense, the lender will get in trouble with the FSA.
The best way for them to pay back the loan will be through a personal equity plan (PEP) or an Individual Savings Account (ISA) (ISA). Even the cash from a personal pension plan (PPP) that is not taxed will be fine. But the borrower will have to show proof to the lender that these financial plans are in place. Just saying that you plan to do something isn't enough.
So far, responses show that different lenders have different ideas about how the FSA's rules should be used. Take the Nationwide Building Society as an example. Their new rules say that you won't be able to get an interest-only mortgage if you plan to pay off the loan with an inheritance or if you're counting on a pay raise in the future. Even if you plan to pay for your repayment investment with bonuses instead of your regular income, you will still have to show that the bonus scheme is real and that the amount you expect to save from bonuses is reasonable.
But the Nationwide Building Society will agree to an interest-only mortgage if you are not a first-time buyer, the mortgage you want is less than two-thirds of the new property's value, and you have at least GBP150,000 in net equity in your current home.
A lot of mortgage advisers seem to agree that interest-only mortgages should only be used as a last resort when money is tight. That's because no matter what kind of investment the borrower uses to pay off the mortgage, the returns are never guaranteed, and the borrower might not have enough money at the end of the term to pay off the mortgage in full. This means there's a chance of something going wrong. Because of this, many advisors would rather be safe and suggest a repayment mortgage, where there is no chance of a shortfall. (They may be thinking about how important it is to avoid risk when giving advice, but this is covered by their professional indemnity insurance!)
Still, some financial advisers will say that an interest-only mortgage can be helpful if the borrower just wants to use the lower payments as a stopgap for, say, four or five years before switching to a repayment mortgage. The FSA will still expect the borrower to show proof to the lender that a good savings or investment plan is in place before the borrower can get out of an interest-only mortgage.
But we think that if advisors do suggest an interest-only mortgage, they should suggest a plan where the borrower can make extra payments without being penalised. With these types of mortgages, the borrower only has to pay the monthly interest. When extra money comes in, it can be used to pay down the balance of the mortgage. There are a lot of mortgages like this out there. Most mortgages let the borrower pay back at least 10% of the loan amount each year without penalty, but you should check the details before you sign up for a mortgage.
