Michelle Niziol,director of IMS Independent Mortgage Solutions, explains all about interest-only mortgages.
Interest-only mortgages have made a return to the market but these products are still few and far between. You need to have a considerable amount of equity in your property and be on larger than average incomes to be able to obtain one.
What is an interest-only mortgage?
With an interest-only mortgage your repayments only cover the interest on the amount you borrow, so you will need to have a repayment plan for how you will pay off the capital element of the loan at the end of the mortgage.
If you have a £100,000 interest-only mortgage for 25 years, you’ll pay the interest on the amount you borrowed each month. When the 25 years are up, you’ll have to pay the full £100,000.
The rise and fall of the interest-only mortgage
These types of mortgages were very popular 20 to 30 years ago with homeowners who wanted smaller monthly repayments and hoped to benefit from increasing house prices in order to repay the mortgage.
However, the majority of interest-only mortgages were taken out without any proof that borrowers could actually pay off their debt, which would not happen today due to stricter regulations introduced by the Financial Conduct Authority (FCA) in April 2014.
Due to this stricter criteria the majority of lenders removed interest-only products from their mortgage range as they were seen as riskier loans. And so, the number of interest only mortgages has fallen year-on-year since the financial crisis hit almost 10 years ago.
There are of course still homeowners paying off this type of mortgage. Figures from the Council of Mortgage Lenders (CML) show there are more than one million interest-only mortgage customers.
It’s estimated around 600,000 interest-only mortgages will mature before 2020, with around half still owing money. Age Partnership last year found these borrowers were typically 70-years old and have £66,035 in outstanding debt.
The FCA has insisted that lenders contact existing borrowers to inform them of the need to plan for repayment.
When it comes to remortgaging, many may wish to move to another interest-only mortgage deal. Whilst some lenders have re-entered the market and there are more interest-only products available, these types of mortgages now come with very strict lending criteria and tend to be granted only to the wealthy.
Applicants seeking these types of mortgages, typically need to earn at least £75,000 and be able to prove that they have repayment vehicles in place to repay the mortgage. The majority of lenders will only lend to applicants with 50% equity in their property – 50% loan to value (LTV), although there are some that will go up to 70 to 75% LTV.
With the strict lending criteria in place, I always make sure that my clients have evidence of the repayment method, whether that be the sale of the house, inheritance or investments, before I apply for an interest-only mortgage for someone.
What to do if you have a shortfall?
There are many cases where the mortgage holder has a shortfall and is unable to pay back the loan at the end of the mortgage term. There are a number of things you can look to do to get yourself out of this situation.
Benefit from rising house prices
Some borrowers will have benefited from the rise in house prices and therefore be able to pay off their loans by downsizing or using savings to pay off the loan.
Others will also be able to take advantage of rising house prices and re-mortgage to a repayment based product. They are likely to have a smaller loan-to-value due to the increase in house prices and this will enable them to obtain a better interest rate.
However, expect a shock in the monthly repayments for a repayment-only mortgage compared to interest-only. There can be a significant jump.
Part repayment, part interest-only
Look into part-repayment, part interest-only. Some lenders will allow you to take 50% of the loan on an interest-only basis with the rest on repayment. Monthly repayments will be less than paying on a solely repayment basis, so a good jump for those who need to watch their monthly payments.
Overpay your mortgage
Some lenders allow borrowers to overpay each month by up to 10%. If you are able to afford it, it may be a good option for those who cannot afford to switch to a repayment basis.
Extend your mortgage term
You can also speak to your lender about extending your mortgage term. By doing so your mortgage payments will lower each month, making it easier for you to save to pay off the mortgage at the end of the term.
Repossession remains the ultimate risk to those aged over 55 who may not be able to re-mortgage into retirement or downsize. There is potential for some to convert their mortgage to a lifetime mortgage. This is an equity release scheme that means you can stay in your home and the loan is paid off when you die.
Mortgaging into retirement
Shawbrook Bank has launched a mortgage for interest-only customers who cannot clear their debts. It is available to interest-only borrowers aged between 55 and 75, and they can borrow half the property’s value for 15 years or until they reach the age of 85, whichever comes sooner. There are no penalties for repaying early so the mortgage holder can clear the debt at any time.
Because the borrower is in debt, this product is more expensive than a standard interest-only loan. Shawbrook will charge 6% on a five-year fixed rate mortgage or £750 a month for a £150,000 loan. Other lenders charge around 2% for a similar loan size and fixed term, which would equate to around £250 per month. Significantly cheaper.
Yorkshire Building Society recently teamed up with equity release specialist Age Partnership to give borrowers access to the full range of equity release options. But you should speak to family members about releasing equity from property as it will impact the size of inheritance left to the family.
Top tips for interest-only mortgage holders
- You must have a robust repayment plan in place and be able to evidence how you will repay the mortgage at the end of the term. The lender will check during your mortgage term that your repayment plan is on track to cover your mortgage.
- Your repayment vehicle could be cash you have saved, stocks and shares, pensions, investment bonds, regular savings plans, inheritance (as long as there is proof you have it or will receive it by the time you take out the mortgage), and other property assets.
- The value of investments can rise and fall and it’s possible that you could lose all of your money before you’re able to pay off your mortgage, so it is important to review your financial situation regularly.
- It is very important to speak with your lender and a mortgage consultant at regular intervals during the mortgage term about what your financial circumstances are and what options are available to you. If there are any risks of a shortfall these are identified early and can be managed.
In conclusion, interest-only mortgages do work for some people but you have to be conscious about how you will repay the loan in the end.
If you think you fit the stricter lending criteria and are interested in taking out such a loan, speak with a mortgage consultant who has access to the whole of the mortgage market and find out what your options are.