Summary
More and more homebuyers are taking out interest only mortgages. We examine why and discuss why it can be a risky option.
Mortgages. Why interest only can be a risky option.
Author: Anna Richardson
The Council of Mortgage Lenders' figures are showing a growing
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There's a good reason for this upturn, and that's because the monthly payments are so much lower than with a repayment mortgage. All you have to do is pay the interest, delaying the repayment of the capital itself until the end of the mortgage term when it is paid off in full.
Getting an interest only mortgage is an easy way to avoid having to change lifestyle habits like eating out and holidays – and having a mortgage is incredibly affordable this way. However, we think that there could be a lot of people in trouble in the future when they realise that they didn't start saving soon enough for this eventual lump sum payment.
The Financial Services Authority (FSA) have voiced concerns about homebuyers potentially getting an interest only mortgage and not making sufficient provisions to pay off the capital, so as a result mortgage lenders have tightened up the rules on interest only mortgages. Now you need to provide proof of an alternative savings fund to cover the capital, before they will agree to lend you the money. The most common ways to save include pensions and ISAs, regular payment schemes that could potentially save more than the capital required. Of course, they may also fall short. The main danger is that the homebuyer will go and cancel the savings plan once the mortgage has been agreed.
If a borrower decides not to save money to cover the capital, the only option would be to sell the home and then buy a home of less value when the time comes to repay the capital. This is not a scenario that the FSA and lenders want to be faced with, especially as property prices cannot be depended on.
Back in the 1970s and 1980s interest only mortgages were very popular – homebuyers would take out an endowment policy to cover the capital repayment at the end of the term. However, we all heard in the news recently about endowment policies under-performing – many borrowers were not able to cover the capital because of an endowment shortfall. They were considered to be a ‘guaranteed' way of saving, but they did not fulfil their promise. In a similar way, there's no way to be sure that an investment product will have performed as well as is needed when it comes to paying back the capital in 20 years time.
Did you Know?
Early methods of transferring or distributing insurance risk were practiced by Chinese and Babylonian traders as long ago as the 2 nd and 3rd millennia BC. Chinese merchants traveling treacherous rivers would redistribute their stock across many boats to limit the loss due to any single boat sinking. The Babylonians devised a system which was recorded in the Code of Hammurabi, circa 1750 BC and was used by early Mediterranean sea traders. If a trader received a loan to fund his shipment, he paid the lender an extra sum in exchange for a guarantee that the lender would cancel the loan should the shipment be accidentally destroyed or stolen.
Did you Know?
If you smoke, the cost of your life insurance will be about double. And it's no use just giving it up a few weeks or months before you apply. Most life assurance companies say you mustn't have smoked for a least 12 months prior to the application – and some insurers extend this to 5 years!
Did you Know?
When looking for low mortgage rates you're sure to face the decision between choosing a cheap rate or a higher rate mortgage but which has very low, or no up front costs.
Everyone has seen mortgages advertised with incredibly low interest rates on both the Internet and in the national press. Experience has shown the mortgage lenders that it's a low headline interest rate that pulls in the borrowers. The problem is that these ultra low rates force them to replenish their profits in other ways. A common solution is high arrangement fee.
Arrangement fee are charged to supposedly cover the cost of managing the mortgage application and reserving the advance. These fees can normally be rolled in with the mortgage advance but some lenders require them to be paid in up front. And the fees do vary enormously, not only between lenders but even between mortgage products marketed by the same lender. So keep your eyes skinned!