An interest-only mortgage is an alternative to a traditional repayment mortgage. It’s cheaper but, as monthly repayments only cover the interest on your home loan, it leaves borrowers with a potentially big problem: at the end of the term they will still owe the capital borrowed at the beginning.
It’s hard to get an interest-only mortgage now but they used to be incredibly popular. According to the Council of Mortgage Lenders, around a third of mortgages taken out in 2007 were interest-only.
And that's left thousands of borrowers in a tricky position.
What’s the problem?
The Financial Conduct Authority (FCA) estimates that around 600,000 interest-only mortgages are set to reach the end of their term by 2020, and that half of those have no means to pay back the debt.
The introduction of new mortgage rules last April has made life even more difficult for these borrowers.
The Mortgage Market Review (MMR) means interest-only mortgages are harder to come by - you'll have to convince your lender of exactly how you plan to repay the capital at the end of the term. On top of that, getting approved for any mortgage is subject to far more in-depth affordability tests.
As a result many people on interest-only will be stuck if they want, or need, to remortgage at the end of the term.
Switch to a repayment mortgage
An obvious option is to switch to a repayment mortgage. This will mean an increase in your monthly repayments. However, the current low rates on offer mean now is a good time to switch and limit so-called 'payment shock'.
For example, if you are currently paying a £100,000 mortgage at 4% on an interest-only basis you’ll be repaying £333.33 a month. If you switched to Yorkshire Building Society’s best buy two-year fixed rate at 1.07% you’d pay £380.04 a month on a repayment basis, about £47 more.
However, many people with bigger mortgages or those who are ineligible for the cheapest mortgages on offer will have to consider other options.
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Split between interest-only and repayment
Leeds Building Society has introduced part repayment and part interest-only mortgage deals.
They could be suitable for borrowers with interest-only loans who want to start paying off the capital, but would find a full repayment deal too expensive.
[SPOTLIGHT]Customers looking to borrow up to 50% LTV with Leeds can have the whole mortgage on interest-only. Another option is a 'part and part' approach such as half interest-only and half repayment.
You’ll need a repayment strategy for the interest-only part - Leeds will accept sale of the property on the proviso that it has at least £150,000 equity when you take out the mortgage.
The rules are tighter if you need to borrow more of your property’s value and part-and-part deals are only on offer up to 75% LTV.
At this LTV the sale of the property is not an acceptable repayment strategy, although you can use the equity from the sale of 'other' properties such as buy-to-lets.
Equity release
Equity release is aimed at borrowers aged over 55. It allows homeowners to access the equity or cash tied up in their home either as a lump sum or several smaller amounts.
Borrowers carry on living in the property and the debt, and interest, is repaid when they die.
Research from retirement income specialists Age Partnership found that the number of borrowers using equity release to pay off an interest-only mortgage has tripled since the introduction of MMR, as many older borrowers are now finding it almost impossible to remortgage their debt.
Simon Chalk, equity release expert at Age Partnership, said: "Importantly, unlike with a normal mortgage age isn’t a problem with an equity release plan. In fact, it’s the exact opposite; the older the borrower, the more money they can release."
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Find an acceptable repayment strategy
If you want to stay on your current interest-only deal you need to work out how you’ll repay the capital at the end.
Your lender may have written to you about this. They may also want to check up on how your plan is going and discuss alternatives with you if your strategy is not working out.
Acceptable repayment strategies vary between lenders. Halifax, for example, will accept 80% of a stocks and shares portfolio’s current value and 80% of the equity in a second home.
Meanwhile Santander will accept sale of the mortgaged property, but only if you have £150,000 of equity at the beginning of the term. It will also consider endowments, ISAs and other investments but will make various assumptions about values and growth.
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