Is An Interest Only Mortgage A Long-Term Strategy?
When the pressures begin to build on balancing the household budget, does it make sense to use the mortgage as a safety valve by switching to an interest-only loan to cut monthly repayments?
That topic made the lead item on the BBC Radio 4’s Today programme recently, as two financial experts debated the wisdom of the move.
Terry Smith, City broker and founder of the Fundsmith fund management operation, warned listeners that interest-only mortgages are “no better than renting, really,” with all the responsibilities and costs of ownership on top.
American economist DeAnne Julius didn’t agree: she suggested interest-only loans can “make sense for certain people at certain times in their lives”. She also raised the inflation argument: if rising prices shrink debts, will it become much easier to repay lump sums later in life?
Their discussion followed a report by the Financial Services Authority (FSA) which noted that the value of interest-only mortgages soared by £99 billion between the third quarter of 2007 - when the housing boom hit the buffers - and the end of 2010. The number of interest-only borrowers rose in that time, says the FSA, by more than 369,000.In many cases, however, the FSA puts this switch down to ‘forbearance’ - where lenders suggest a switch to lower, more affordable payments to avoid a default and possible repossession.
The regulator is worried by this trend. If borrowers pay only the interest charged on their loan, how will they eventually pay the lump sum owned on their home when the loan matures, without selling up and becoming homeless?
Andrew Hagger at financial website Moneynet.co.uk says: “When prices were rising, interest-only borrowers had a safety net. They could always sell, keep the profit and pay the loan back. “With prices static or even falling, borrowers are more exposed. Lenders want some guarantee that a savings vehicle is in place - an ISA pot, or some other investment - to pay off the lump sum at the end of the mortgage.”
Moneyfacts magazine lists around 40 providers of interest-only mortgages. They range from ‘tiddlers’ like Stafford Railway BS (max LTV 75%) to giants like Nationwide BS (66%, with minimum equity £150,000) and HSBC (75%, min salary £25,000). Halifax also has a 75% ceiling.
In theory, switching to an interest-only home loan can release cash to pay other household bills: on the average UK mortgage of £109,000 and average borrowing costs of 3.5%, this switch could save around £230 per month.That could be a godsend for families under pressure.
Apart from buy-to-let landlords, who prefer interest-only mortgages as a tax-efficient way of guarding rental income, interest-only loans tend to be used by wealthy, older homebuyers and self-employed workers able to use regular bonuses or lump sums to pay off chunks of their mortgage.
“We have had cases,” says Ray Boulger at leading broker John Charcol, “when investors with bonds paying £100,000 per year tax-free are not accepted for an interest-only mortgage. Some lenders only accept taxable income as reasonable security.” Lending conditions applying to interest-only loans have been greatly tightened since 2007.
“Because most lenders won’t accept interest-only loans beyond 75% LTV, a remortgage above that level has become increasingly difficult”, says Boulger. “Since 2008, remortgage activity for borrowers needing more than 75% LTV has been low.” Another snag is that borrowers trying to move in the past 12 months have found it increasingly difficult to carry or ‘port’ an existing interest-only mortgage to their next home.
“Ironically, some clients whose lender has refused to allow an existing mortgage to be ported have had a mortgage application declined on grounds it is unaffordable, even when they want to trade down and have had no arrears,” says Boulger. “This is because of the much more onerous affordability calculations now being used by some lenders, which hit older borrowers particularly hard.”
Critics claim the FSA, having failed to regulate mortgages rigorously before the credit crunch, is now forcing lenders to take intransigent and unrealistic positions with would-be borrowers. “Someone who is, for example, in their 50s will often have to have sufficient income to be able to afford a repayment mortgage to 65 or perhaps 70 to meet a lender’s current affordability calculation,” says Boulger.
“While this usually makes sense for those with a repayment mortgage, it is ridiculous for someone with an interest-only mortgage and a robust repayment plan. It means some potential movers decide not to move, thus further restricting activity both in the housing market and also other economic activity which takes place when people move home.”
Fearing an FSA crackdown, lenders increasingly insist that borrowers who take out interest-only mortgages also have one of the most risky types of repayment vehicles, such as endowments and stock market ISAs, intended to produce a lump sum at the end of the loan. Boulger says: “Some lenders, including the Woolwich, insist these plans have been in place for at least a year.
“A small percentage of borrowers have an attitude to risk that means they would choose a stock market ISA as a way of repaying their mortgage, but this probably only applies to less than 20% of interest-only borrowers.
“Low-risk options to repay an interest-only mortgage, such as using the ERC (Early Repayment Charges) with free overpayment facility offered on nearly all deals, particularly suitable for the self-employed or anyone with a variable income, are now rarely considered acceptable by lenders! It’s madness!”
He adds: “I accept lenders should require a robust repayment plan before granting an interest-only mortgage, which could include a whole variety of things, but they should not insist on a repayment vehicle, which I define as a stock market based investment into which one makes regular monthly payments.”
For borrowers in trouble, interest-only mortgages can be a sensible way of buying time, but the process is becoming more tortuous. “Pre-credit crunch, most lenders would have allowed this without too much difficulty, possibly depending on how much equity was held in a property,” says Boulger. “Since then, some requests to switch to interest-only when a borrower has sensibly requested a temporary switch because of cashflow problems, perhaps caused by redundancy, have been refused. “Subsequently, the lender may allow such a switch when the mortgage goes into arrears - exercising forbearance only after the borrower has damaged their credit rating by being forced into arrears by a lender’s intransigence. “It’s hardly an encouragement for borrowers to be open with their lender!”
While borrowers in difficulty should tell their lender, a broker might also be able to help - though borrowers need to have at least 25% equity in a home to have much hope of switching lenders. Other borrowers in trouble sometimes take a bridging loan prior to selling their home to preserve a personal credit rating which could be threatened if a mortgage went into arrears.