The Interest-Only Mortgage Timebomb: How to Protect Yourself
5 minute read
It has recently been reported that as many as 11,200 families with interest-only mortgages are at risk of losing their homes in the next year, as their mortgage terms come to an end but they don’t have the funds in place to repay lenders the amount they originally borrowed. Here, we take a look at interest-only mortgages and how they work, and explore some of the potential options to protect yourself if you are in the position described above.
What is an interest-only mortgage?
An interest-only mortgage is a mortgage where the monthly payment only covers the interest accruing on the amount you have borrowed. This is in contrast to a repayment (or capital and interest) mortgage, where the monthly payments are calculated to both cover the interest and repay the amount borrowed (the capital) over the agreed term. As the balance of an interest-only mortgage isn’t reduced by the monthly payments, the full amount borrowed is still outstanding at the end of the mortgage term. It is important, therefore, for an investment policy or plan (sometimes referred to as a repayment vehicle) to be put in place that will allow you to repay the mortgage balance in full at the end of the mortgage term.
Advantages of an interest-only mortgage
The main advantage of an interest-only mortgage is that the payments are significantly lower than on an equivalent repayment mortgage. This makes the mortgage more affordable and gives the borrower more money in their pocket to either spend or save. Because interest-only mortgages are more affordable, it also has the potential to allow homebuyers to purchase a more expensive property than if they were taking out a repayment mortgage.
Disadvantages of an interest-only mortgage
Because the mortgage payments do not reduce the balance, it is important to have a repayment plan in place to clear the total mortgage debt at the end of the term – if you don’t, you risk losing your home. For many interest-only borrowers who took out mortgages at the height of their popularity in the 1980s and early 1990s, the repayment plan took the form of an endowment policy, a type of life insurance which paid out a lump sum on maturity, or on the death of the policyholder. Unfortunately, these types of policy, which were both popular and performing well at the time, began to lose value over the years, with the result that many have been projected to pay out less than the target amount and, crucially, less than the amount borrowed on the mortgage.
Why are so many people at risk of losing their homes?
Interest-only mortgage customers whose endowment or investment plans are not paying out enough to pay off the mortgage debt are left in the difficult position of owing money to the lender that they may not be in a position to repay. This could mean that they have to sell up and move to a smaller home (if there is sufficient equity available) or, in a worst case scenario, face the lender repossessing the property. In some cases, customers may have no repayment vehicle in place whatsoever. As to the scale of the problem, interest-only mortgages were once extremely common, making up four-fifths of all mortgages sold at the height of their popularity. There are now around 1.8 million borrowers with an interest-only loan, which equals about one in five of all mortgages.
What are the options?
Many borrowers caught in this situation may be unable to take out a new interest-only or repayment mortgage to pay off their existing lender, either because they are too old to qualify for a mortgage or there is not sufficient equity in the property. However, there are some other options available. If there is sufficient equity in the property, then selling the home to pay off the existing mortgage and buying a smaller property may be an option.
Another popular solution is to take out an equity release or home reversion plan to clear the existing mortgage, which allows the homeowner to continue living in the property without having to make monthly payments; the amount borrowed and any interest accrued is typically repaid when the homeowner dies or moves into permanent care. Another type of product, the retirement interest-only mortgage, works in a similar way, but the borrower repays the interest monthly as they would on a standard interest-only mortgage.
What to consider before taking out an interest-only mortgage
As with any mortgage, the primary consideration is to be realistic about how much you can borrow and your ability to afford the monthly payments. For interest-only mortgages, the other important consideration is how you will repay the mortgage debt at the end of the agreed term. The lender needs to agree that you are using an appropriate repayment vehicle; typical examples include stocks and shares ISAs, pension schemes, investment bonds and unit trusts or with some lenders, albeit a small group in today’s market, the property the mortgage is secured against.
At Just Mortgage Brokers, we have access to a wide range of mortgages and financial products from across the UK lending market. Whether you are an existing borrower with an interest-only mortgage, or are looking to take out a new mortgage, get in touch with us today to discuss how we can help.