With interest rates at historic lows, interest-only mortgages might be appealing, but what happens when the mortgage term ends?
Originally interest-only mortgages were taken out with an endowment policy that would pay off the mortgage debt, but as the popularity of endowments decreased they were dropped. This was this type of mortgage was at its most popular in the 80's and 90's. However, endowments suffered from bad press when some institutions mis-sold them and they ended up not having enough money to cover the principle of the mortgage owed.
The incentive to borrowers is that the principle of the mortgage loan is not paid as a monthly repayment, only the interest is.
Interest-only mortgages are commonly taken out by Buy to Let investors because they are able, in some countries, to re-claim the tax payable on the interest, making the monthly repayment even lower and subsequently making the yield appear better.
One of the worrying things about the popularity of interest-only loans is that many do not have a payment plan in place for when the mortgage term ends and are relying on selling the property for a higher price than they paid for it to cover the cost.
The FSA (Financial Services Authority) estimate that between 2005 and 2009 over 1 million people were sold interest-only mortgages without a repayment plan in place for the principle of the loan.
It is debateable as to whether or not interest-only mortgages constitute responsible lending; one of the main factors of this is the financial situation of the customer, the bank need to be sure that they can pay the principle of the loan when the time comes.
Interest-only loans vary slightly between the UK and the US; in the US the interest-only payments are only for a set period between 5 and 10 years. After this period the loan will convert to a repayment loan. Where as in the UK, interest-only repayments can be for the full length of the loan period.
How mortgages are changing
As lending restrictions tightened after the financial crisis the availability of interest-only mortgages decreased, the ones that are now available have a higher rate due to the higher risk associated. Some lenders are not offering them at all where as other will restrict on who they lend them to, (for example not allowing first-time buyers to take one out).
Some banks are trying to persuade borrowers on interest-only mortgages to change to a repayment loan, for example Santander who will move customers who are on interest-only mortgages, with less than 25% equity in their home, on to repayment mortgages.
In the UK the FSA (Financial Services Authority) and the Ombudsman are looking to review interest-only mortgages in early 2011.
What makes interest-only attractive?
The primary attraction of an interest-only mortgage initially is the lower monthly repayments. However, as banks want to move customers onto repayment mortgages, many people will find they are no longer able to afford their monthly repayments.
Whilst interest only mortgages are appealing from a cost point of view, they are not without a certain level of peril. Aside from banks trying to move clients into repayment mortgages when times are hard, if interest rates rise, and the housing market is sliding, the individual ends up in a situation with rising costs on an asset that is becoming worth less, leading to negative equity.
As a rule of thumb, there are really only a few occasions when interest-only mortgages are practical:
- When buying with a guaranteed way out of a property investment (i.e. another buyer already in place).
- If there is a substantial underwritten rental or lease guarantee in place.
- You are purely using the facility as an initial payment holiday, and are sure you can afford a full repayment mortgage.
Whilst traditionally house prices have always risen over time, the amount of time that can take does change when the financial markets are volatile. When markets are booming, interest-only mortgages will look good, unfortunately when times change, the same financial tool will turn on you and not only leave you with higher costs, but no equity in the property either.
- Tuesday 14 September 2010