Lenders clamp down on interest-only mortgages

Despite a succession of Bank rate reductions - now down to 5 per cent - life hasn't got much easier for the typical homeowner and an increasing number of borrowers are turning to interest-only mortgages to ease the pressure on their monthly outgoings.

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However, there are signs that lenders are now becoming more wary of this form of borrowing amid fears that many borrowers are making no provisions to repay the capital at the end of the term.

Abbey will now only lend up to 50% of the property’s value on an interest-only basis unless you can prove that you have a repayment plan in place - this could be an individual savings accounts (Isas), endowment or some other form of savings vehicle – and even then the maximum it will advance is 75%. Royal Bank of Scotland has also restricted the availability of interest-only mortgages – they are no longer available on loans above 90%.

What is the problem with interest-only mortgages?
With a repayment mortgage, your monthly payments go towards repaying some of the capital as well as the interest so by the end of the term your debt is completely repaid. However, with interest-only loans, the monthly payments only cover the interest you are accruing. This means you will still have to repay the initial loan amount once the term of your mortgage has ended.

This isn’t necessarily a problem if you make provisions – traditionally borrowers have taken out an endowment policy alongside their mortgage with the intention that the return on that will cover the capital repayment at the end of the term. While endowments have lost favour, many people now use Isas and other investments as their repayment vehicle. Most mortgage deals now allow borrowers to make overpayments, so some plan to repay the capital that way.

However, there is growing concern that a rising number of people with interest-only mortgages have no repayment plan in place – instead they are focusing on the here and now and see interest-only loans as a way to minimise their monthly outgoings.

The monthly cost for someone borrowing £150,000 over 25 years at a rate of 6% is £877 on a repayment basis, but you would pay just £625 a month with an interest- only loan.

With rising inflation it is perhaps easy to understand why. Strong house price growth in recent years has meant that many people have really stretched themselves financially to get on to the property ladder. Some have opted to go interest-only so that they have a bit more money each month which can be used to set up their home.

The danger is that these people never get around to switching to a repayment loan or setting up a saving vehicle to pay back the capital. And with inflation pushing up the cost of other household bills and millions of homeowners struggling to make ends meet, interest-only mortgages are becoming a more popular option.

According to the Council of Mortgage Lenders (CML) the percentage of people opting for interest-only mortgages has leapt from 13.5% to 31% in the last five years alone.

While choosing interest-only may help ease things financially in the short term, these people could be storing up big problems for themselves in the future.

Generally, the best advice if you have an interest-only mortgage without a repayment vehicle is to move to a repayment mortgage as soon as possible - you can compare rates with our mortgage comparison tool. Work out your finances and look at the level of repayments you can afford.

If you can’t afford to switch the entire mortgage over to a repayment loan, many lenders will allow you to have part repayment and part interest-only – that way you are at least repaying some of the capital down now. Another option is to make overpayments – check with your lender if this is permitted. Many mortgage deals now allow borrowers to repay at least 10% of the capital each year.  

Some good news for homeowners
The problems for many borrowers have been exacerbated by the credit crunch. Even though interest rates have fallen by 0.75 percentage points since December, mortgage rates have been rising because of the shortage of funds on the wholesale markets. Higher rates have meant that many of those needing a new mortgage, whether it’s because their old deal has come to an end or they’re moving house, have faced a big leap in monthly payments. However, we are at last seeing signs of some improvement in the mortgage market.

A number of lenders, including Halifax, Nationwide and Abbey, have reduced some of their mortgage rates over the last few weeks. And First Direct, which stopped offering mortgages to all-but existing customers in March, has announced that it will accept applications from new borrowers again.

What are the best rates available?
If you are looking for a low rate, then HSBC’s two-year discount at 5.43% is an attractive deal. It is available for loans up to 90% and there is a £999 arrangement fee although those remortgaging receive a free valuation and free legal work.

For those wanting a longer-term, variable rate deal, Woolwich’s lifetime tracker at 0.74 points above Bank rate is a good option – the current pay rate is 5.74%. There is no arrangement fee and no early redemption charge (ERC), but it is only available for loans up to 60%. If you need to borrow more than that, HSBC has a lifetime tracker at 5.99%. Again, there is no arrangement fee or ERC so you can remortgage without penalty at any time.

However, given the recent statement from the Bank of England about the outlook for inflation, you may prefer a fixed rate mortgage in case interest rates rise. If this is the case, ING Direct offers the market leading two-year rate at 5.69%. It is available for loans up to 75%, but the arrangement fee is very high at £1,999 so it will only offer the best value to those with large mortgages – probably in excess of £250,000.

If you are borrowing less than that, Newcastle building society’s three-year fix at 5.75% is worth considering. The fee is £999 and it is available for loans up to 85%.

Those wanting longer-term security can fix at 5.75% for five years with Abbey. The deal has a £1,499 arrangement fee and is available for loans up to 75% of the property’s value.

If you are unsure about which is the best deal to go for, call one of our mortgage advisers for tailored advice on 0845 345 5705.

Have your say: Have you got an interest-only mortgage? If so, are you worried about how you will repay it? Or are you having problems getting a mortgage because of the credit crunch? If you need any sort of mortgage advice, visit our forum as some of our members may be able to help.

Disclaimer: Please note that any rates or deals mentioned in this article were available at the time of writing.

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