Are interest-only mortgages evil?

by John Fitzsimons on 03 June 2010  |  5 comments
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With lenders ditching them or making them much tougher to get hold of, is there still a place for the interest-only mortgage?

Today's debate is on whether interest-only mortgages are a good idea, and whether they have a role to play in the UK mortgage market.

We asked David Hollingworth, head of communications at broker L&C Mortgages, and Richard Barker, product manager at Norwich & Peterborough Building Society.

Richard Barker, product manager at Norwich & Peterborough Building Society

Ditch interest-only 

A big concern for any mortgage customer taking out an interest-only mortgage is the question of how they will repay the loan at the end of the term.

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As the customer will be paying only the interest on the mortgage each month, they need to find another means by which to repay the capital. This will typically be in the form of an investment vehicle on which returns are not guaranteed and there exists a risk that the debt will not be repaid.

Some individuals will be content to rely upon inflation and house price growth to cover this; however, over a period of stagnating growth and potential house price deflation this may not be a realistic solution.

Without repaying the capital over time, the customer can severely inhibit their options with regard to moving house or choosing the best mortgage deals. If house price growth remains low and an accompanying investment (designated to repay the capital) does not perform, a borrower could be saddled with a mortgage debt well into retirement.

Although monthly payments will typically be lower for interest-only mortgages, rises in interest rates can result in much more pronounced increases in monthly payments. For example, on a £200,000 mortgage, if a customer were to experience a rise in payable rate from 3% to 5%, an interest-only customer’s repayment would increase by around £332 compared to only a £225 increase for a repayment customer. The greater ‘payment shock’ can have a significant impact on someone’s monthly budgeting and would be a particular concern in the current environment where the likelihood of future rate rises is high.

Any associated mortgage life assurance (unless this is included within an accompanying endowment policy) will be more costly since this will need to be taken on a level term basis rather than decreasing term commonly taken out for repayment mortgages. 

Finally, choosing an interest-only mortgage can significantly restrict the number of deals available to a mortgage customer. Since the onset of the credit crunch, many lenders have tightened their interest-only criteria which has typically resulted in a reduction of the maximum loan-to-value (LTV) on this type of borrowing. It’s not uncommon for lenders to limit the maximum LTV of this category to 75% (on average 5 or 10% below the equivalent maximum LTV for repayment mortgages).

Furthermore, some lenders have pulled out of the interest-only market altogether as it’s perceived to be riskier than standard repayment mortgage business. As a consequence, if the customer is unable to provide a reasonable deposit, but wants an interest-only mortgage, they could be restricted to a limited number of lenders and products.

David Hollingworth, head of communications at L&C Mortgages

Interest-only has its place

Interest-only mortgages have been the subject of some controversy in the past and it looks like their reputation could be called into question once again, as lenders start to edge borrowers toward repayment mortgages. 

Lloyds Banking group has tightened up on what is an acceptable repayment vehicle for an interest-only loan, following in the footsteps of plenty of other lenders that have rationalised their interest-only criteria.  However, it has also altered policy to require large loan borrowers (above £500k) to take their entire mortgage on a repayment basis. 

For those that are still allowed an interest-only mortgage with Lloyds, the interest rates are higher.  This goes further than other lenders and when the largest lender makes such a move, it’s clearly significant.

So does this mean that interest-only mortgages are a bad idea for everyone?  The short answer is of course no.  Interest-only mortgages have been around for a long time and there’s no reason not to use interest-only so long as all the risks are understood. 

There have been examples of those risks not being clearly explained, notably in the case of endowment mis-selling, when borrowers were not correctly informed of the downside of the endowment failing to meet its projected target.  

In recent times those taking an interest-only mortgage will certainly have received repeated explanation of how an interest only mortgage works.  They should also have been clear of the responsibility of the borrower to ensure that a repayment vehicle is in place and the potential risk associated with the investment.

Many borrowers will have historical repayment vehicles, whether they are ISAs, endowments or another investment vehicle, and will have maintained a steady drip of funds to provide for the ultimate repayment of their mortgage.  Only time will tell whether their decision to speculate on achieving a higher growth rate on their money is vindicated but on the basis that they understand the downside they should surely still be able to pursue their strategy.

Of course the other problem with interest-only has been the growing number of borrowers failing to take any repayment vehicle at all.  In some cases this will have been taken as a seemingly cheap option to aid affordability or an intention to rely on ever-increasing property prices to eventually cover the debt and some. 

However, many interest-only borrowers will understand their commitments and will have a definite plan in place.  For example, a sizeable proportion of income may come from bonuses that are paid only once a year, so overpayments will be made on a more ad hoc basis to bring down the capital balance. 

Borrowers do need to show some discipline in sticking to their repayment plans and reviewing whether those loans remain on track. Any borrowers that have failed to implement a repayment plan either need to get on and do it or strongly consider if interest-only is really for them. 

However, whilst it makes complete sense for lenders to ask questions about repayment vehicles to ensure that they have something in place, borrowers that have long standing plans and understand the risks should certainly be able to continue on an interest-only basis.

So what do you think? Would you take out an interest-only mortgage? Let us know your views via the comment box below!