The Deadliest Home Loan!

By Cliff D'Arcy
July 6, 2006

I see that the Council of Mortgage Lenders (CML, a trade association which represents almost all UK mortgage lenders) has arranged a seminar on interest-only mortgages in November.

I suspect that some CML members are becoming increasingly nervous about the rising number of homebuyers who are taking out interest-only mortgages. These are home loans where your monthly payments consist purely of interest, unlike repayment mortgages, where each month that goes by sees a little more chipped off your debt.

So, what's the big deal? After all, weren't interest-only mortgages incredibly popular in the Seventies, Eighties and early Nineties, when the majority of borrowers preferred to take out interest-only loans backed by endowments, rather than repayment mortgages? (A mortgage endowment is a life assurance policy which pays off the debt if a borrower dies, and includes an investment element aimed at paying off the mortgage debt after, say, 25 years. Sadly, many of these policies have under-performed, leaving millions of borrowers with substantial shortfalls.)

The problem is that, according to CML data, over 200,000 homebuyers arranged an interest-only loan last year without any repayment vehicle in place, including almost 61,000 first-time buyers. What's more, in the first three months of 2002, only one in eleven new mortgages (9%) was interest only. However, in the last quarter of 2005, interest-only loans accounted for almost a quarter (23%) of new mortgages. Over the same period, the proportion of first-time buyers arranging interest-only mortgages has risen 2½-fold, from 6% to 15%.

Indeed, financial watchdog the Financial Services Authority (FSA) has expressed concerns that so many homebuyers are arranging interest-only loans without taking steps to repay their mortgage debt. Also, lenders and mortgage brokers are starting to worry that some of these homebuyers may file mis-selling claims in the years to come, arguing that it was not in their best interests to have a bare interest-only home loan.

So, why are more and more homebuyers and movers arranging interest-only loans? The simple answer is that the monthly repayments are much lower, because you don't pay off your debt until the end of the mortgage term. Furthermore, with house prices at record highs, getting an interest-only mortgage is the only way that many aspiring homeowners can stretch themselves to reach up to the first rung of the property ladder.

For example, a £100,000 interest-only loan with an annual interest rate of 5% costs £416.67 a month, compared to £584.59 for a 25-year repayment mortgage, which brings down the cost by over £2,000 a year. Then again, having an interest-only home loan without some method of repaying your debt is a high-risk strategy, because it relies on you making your own financial arrangements to repay your mortgage at the end of its life.

Another problem is that rising interest rates hit interest-only borrowers harder. For example, if the interest rate on the above mortgage were to rise from, say, 5% to 6% a year, an interest-only borrower would have to cough up an extra £1,000 a year. However, a borrower with a 25-year repayment mortgage would see his/her annual repayment increase by £717, or £283 less.

Sadly, if my reading of this trend is correct, the proverbial chickens will eventually come home to roost for thousands of these borrowers. If inflation (rising prices) and wage growth stay low, then these borrowers' debts will not diminish as rapidly as they did in the past, making them more stubborn and harder to clear.

Furthermore, leopards don't change their spots, so people who buy a home while inadequately managing their finances are unlikely to acquire better budgeting, spending and saving skills in future, regardless of their best intentions. Without a doubt, some homeowners won't give a second thought to their interest-only loans, secure in the knowledge that ever-rising house prices will make their problem vanish. Yeah, right!

Personally, I'd rather change my lifestyle than buy a house without the means to repay my housing debt. Indeed, I'd probably give up foreign holidays, eating out and life's other little luxuries in order to make sure that my mortgage debt was reducing each year. However, I suspect that many borrowers will leave it far too late to start tackling their debt. This could mean being forced to sell their home and moving to more modest accommodation or, shock horror, even becoming tenants. So much for the joys of homeowning!

So, what are your options if an interest-only mortgage leaves you feeling vulnerable?

1) Set up a monthly savings plan

If you're saving for ten or more years, you stand an excellent change of reaping higher returns from shares, rather than cash. Hence, you could open a shares ISA and start making monthly contributions to a low-cost investment such as an index-tracking fund. Alternatively, you could start or increase your contributions to a private or company pension and later withdraw a tax-free lump sum to redeem your mortgage.

2) Switch to a repayment mortgage later

If you expect your earnings to be much higher in future (for example, you're a trainee professional such as an accountant, doctor, solicitor or barrister), you could opt for an interest-only mortgage now and then switch to a repayment mortgage after completing your training or gaining professional qualifications.

Alternatively, you might decide to switch to a repayment mortgage when a special-rate deal ends, and you're shopping around for another low-rate deal. In addition, given that we move house every eight to ten years on average, you could go for a repayment mortgage when you make your next house move. Just don't leave it too late, please!

3) Go half and half

If you can't afford the repayments on a £100,000 repayment loan, why not go half and half, with a £50,000 repayment loan and a £50,000 interest-only loan? Going 50/50 is better than nothing!

4) Increase your mortgage term

You could stretch your mortgage over a longer period in order to reduce your monthly repayments. For example, our £100,000, 25-year repayment mortgage at 5% a year costs £584.59 a month. Increasing the mortgage term to 35 years reduces this to a more affordable £504.69 a month, or just £88 a month more than an interest-only loan.

5) Make regular, irregular or lump-sum repayments

You could decide to repay your debt via an informal arrangement, by paying off the occasional lump sum or overpayment. This works best if you have a flexible, offset or current account mortgage, where you won't be penalised for chipping away at your debt as and when you can afford to.

6) Sell up and slum it

If the worst comes to the worse, you can sell your home, pay off your loan, and use the remaining capital to buy a more modest home. This is a sensible option for a buy-to-let investment property or second home, but not for your principal residence. After all, who wants to slum it in their golden years?

7) Cross your fingers and hope for the best!

If all else fails, you could trust to luck and hope that you come by a lump sum from another source, such as from selling your business, gaining an inheritance or winning a Lotto jackpot. Good luck!

As you've probably guessed by now, I believe that if you're forced to fall back on an interest-only mortgage without good reason in order to buy an overpriced house, then you can't afford to buy said property, it's as simple as that. In addition, if house prices start to fall, then you are in a worse position than buyers with repayment mortgages, because your debt won't reduce over time. That could mean falling into negative equity, which partly defeats the point of becoming a homeowner in the first place!

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