Interest-only mortgages are a ticking time bomb
In the halcyon days of the early noughties, when it seemed like the good times would last forever, interest-only mortgages were hugely popular.
The idea was that you paid the interest on your mortgage but didn't actually pay anything off the loan itself, thus making your monthly repayments super-cheap.
There didn't seem to be any risk since rising house prices meant everyone would be able to clear the loan capital when they sold their house.
Of course, that was all about to change. As the credit crunch bit and house prices tanked, many people with interest-only deals suddenly had no way of repaying the capital on their loan and some now owe more than their property is worth - a situation known as negative equity.
Embarrassed by the revelation of their laissez-faire lending attitude, the banks and building societies have cleaned up their act and are now only offering interest-only loans to those who have a clear repayment vehicle (for instance, an endowment policy or ISA) in place and a substantial deposit. And some lenders, such as the Co-operative Bank, have pulled out of the market altogether.
While, this may have reduced lenders' risk, it has left existing interest-only borrowers holding a ticking time bomb. In many cases, the maximum loan-to-value (LTV) for interest-only mortgages is now 75%, while some lenders won't go above 50%.
So, borrowers coming off their interest-only mortgage deals with little or no equity in their property will find that they can't move onto another interest-only deal. Instead, they either accept larger monthly mortgage bills and switch to a repayment mortgage, or are left stuck on their lender's standard variable rate (SVR).
At present, the latter is proving to be the popular choice as SVRs are low. "Many borrowers are surviving currently due to the low interest rate environment," says Andrew Montlake, director of mortgage broker Coreco. But now SVRs are on the rise, this option is becoming increasingly expensive.
What can you do?
If you have savings, you could consider using them to pay off some of your mortgage. Then the switch to a repayment mortgage won't lead to such a huge hike in payments and will mean you have a greater choice of remortgage products.
"Of course, that may not be an easy decision but switching the whole mortgage to repayment could give a big leap in monthly costs," explains David Hollingworth, mortgage specialist at London & Country.
If you don't have the cash to spare, then research your options. "Speak to your lender to see what it will offer you and then, armed with that information, speak to an independent adviser who can review the rest of the market," says Montlake.
Even if you need to move onto a repayment mortgage, the costs may not be as daunting as you feared.
For example, some mortgage providers offer existing borrowers incentives to take out another product with them, so you might find your lender can offer an affordable solution to your problems.
Sadly, it is older borrowers who may suffer the most.
Pensioners coming to the end of a deal or, even worse, reaching the end of their mortgage only to find a shortfall, could find that they are being squeezed by the tightening lending criteria for their age group.
"Most lenders will now only lend to a maximum age of 75, subject to the prerequisite that the mortgage will be affordable," says Hollingworth.
"That could make life very difficult for older borrowers hit by poor investment returns and needing to extend their borrowing life. That is why it always makes sense to take action as soon as possible."
Act now to diffuse the time bomb
Those who find themselves in this situation should contact their lender sooner rather than later, to open up a dialogue and see if their term can be extended and switched to a repayment model in order to give them more time to clear their remaining mortgage.
Lenders do have a duty of care to help and the last thing they want is to actually force someone, especially the elderly, out of their home.
If you still have some time left to run on your mortgage deal, then you should still take action now in order to minimise the problems when your deal runs out.
"If you are in a position where you can start overpaying your interestonly loan, this could make a big difference to your available mortgage options in the future as your LTV decreases," says Montlake.
"While rates are low it is a good time to do this."
So in the post-credit crunch days, with lenders vastly reducing interest-only deals, could they soon become extinct?
"While interest-only may seem to be gasping its last breath, I do not think we will see the end of it totally," says Montlake. "When faced with potential new regulation or in the wake of crises there is often an over-reaction and the pendulum swings too far in the other direction before settling back to a sensible middle ground."
However, borrowers need to learn from the plight of today's interestonly mortgage holders. This type of loan only puts off capital repayment, it doesn't eliminate it. So you need to have a plan in place for how you will one day pay off the capital.
Three-step plan for interest-only borrowers
If it is possible, try to make overpayments on your interest-only mortgage. This will mean that when the time comes to remortgage you will have built up some equity in your property, giving you more mortgage options. Or, if you can afford to, ask your lender if you can switch to a partrepayment mortgage.
2. SPEAK TO YOUR LENDER
Find out what options your lender can offer you. The last thing it wants to do is turf you out of your home so it may be able to help you find an affordable mortgage solution.
3. SPEAK TO A BROKER
Getting advice is essential. A mortgage broker will be able to outline all your options and advise you on the best choice for your individual circumstances.
A “traditional” mortgage, where the monthly repayments entail of repaying the capital amount borrowed as well as the accrued interest, so that during the loan period the capital debt is gradually paid off so by the end of the term the mortgage has been fully repaid. One advantage of a repayment mortgage is that it removes the risk of having a parallel investment (such as an endowment policy or pension), the performance of which is dependent on the stockmarket, such as with an interest-only mortgage.
Every mortgage lender has a standard variable rate of interest, or SVR, on which it bases all its mortgage deals, including fixed and discounted rate and tracker mortgages. When special deals come to an end, the terms of the deal usually state that the borrower has to pay the lender’s SVR for a period of time or pay redemption penalties. The lender’s SVR is, in turn, based on the Bank of England’s base lending rate decided by the Bank’s Monetary Policy Committee (MPC). Every time the MPC raises its rate, mortgage lenders generally increase their SVR by the same amount but when the MPC lowers its rate, lenders are often slow to pass this on or don’t pass on the full cut to borrowers.
The circumstances in which a property is worth less than the outstanding mortgage debt secured on it. Although it traps householders in their properties, the Council of Mortgage Lenders (CML) says there is no causal link between negative equity and mortgage repayment problems. At the depth of the last housing market recession in 1993, the CML estimated 1.5 million UK households had negative equity but most homeowners sat tight, continued to pay their mortgages and eventually recovered their equity position.
A loan in which the borrower pays only the interest on the sum borrowed for the life of the mortgage but, at the end of the mortgage term, they still owe what they originally borrowed as this remains unchanged. The advantage of an interest-only mortgage is the monthly repayment is considerably lower than for a comparable repayment mortgage. Lenders generally insist the borrower also invests in an endowment, ISA or pension savings policy that, on maturity, is intended to pay off the capital loan.
Invidivual Savings Accounts were introduced on 6 April 1999 to replace personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs) with one plan that covered both stockmarket and savings products, the returns from which are tax-exempt. The ISA is not in itself an investment product. Rather, it’s a tax-free “wrapper” in which you place investments and savings up to a specified annual allowance where the returns (capital growth, dividends, interest) are tax-exempt (you don’t have to declare ISAs and their contents on your tax return). However, any dividends are taxed within the investment, and that can’t be reclaimed.
A contract written by a life assurance company to pay a fixed sum (“the basic sum assured”) to the assured person on a fixed date in the future or to their estate should the person die prematurely. The policies normally run for five, 10, 15, 20 and 25 years. Monthly premiums are calculated on the age of the life insured, the basic sum assured required at maturity and the length of the policy, so each policy is unique. The policies can be with-profits or unit-linked (see separate entries). A common investment product during the 1980s, endowment policies were sold alongside interest-only mortgages and designed to provide enough money to repay the capital borrowed at the end of the mortgage term. However, mis-selling scandals and poor investment performance discredited endowments as a mortgage repayment method.