Interest Only Mortgages – FSA Makes Move To Protect Homeowners

The Growing Popularity and Regulation of Interest-Only Mortgages

Abbey recently reported that over 25% of homeowners are opting for interest-only mortgages. The appeal is evident: these loans offer significantly lower monthly payments. For instance, on a 25-year £125,000 mortgage at 5%, the interest-only mortgage payment is £525 per month, compared to £735 per month for a repayment mortgage. That’s an additional £210 each month—a substantial saving.

The primary drivers of this trend are first-time buyers who find repayment mortgages unaffordable and therefore choose interest-only options as a more accessible solution. However, this approach requires a corresponding savings plan to cover the capital at the end of the mortgage term. Unfortunately, many borrowers neglect this critical component, with up to 37% failing to establish a suitable savings vehicle.

In response to these concerns, the Financial Services Authority (FSA) has intervened. Lenders are now required to obtain concrete evidence from borrowers that a plan is in place to address the outstanding capital. Previously, borrowers could merely state their intention to sell the property or other future plans to cover the capital, but this is no longer sufficient. Lenders must now ensure that borrowers have a tangible strategy in place before approving an interest-only mortgage. Failure to comply with this requirement could result in penalties for the lender.

The FSA mandates that borrowers must provide proof of a personal equity plan (PEP), an Individual Savings Account (ISA), or evidence that 25% tax-free cash from a personal pension plan (PPP) will be available to cover the capital. Simply expressing an intention to establish such a plan is no longer acceptable; borrowers must show that the plan is already in place.

Since the introduction of these regulations, lenders have begun to impose stricter criteria. For example, Nationwide Building Society has determined that future inheritance or anticipated pay raises cannot be used as a basis for qualifying for an interest-only mortgage. Similarly, expected performance bonuses will not be considered unless they are guaranteed.

Existing homeowners face fewer stringent checks. For those borrowing less than two-thirds of the value of the new property and with £150,000 in net equity in their current home, Nationwide will accept them as customers without the same rigorous documentation requirements.

Overall, mortgage advisors generally advise against interest-only mortgages due to the risks involved. Repayment mortgages ensure that the total loan amount is paid off by the end of the term, whereas a separate savings plan may fail to meet expectations, leading to potential shortfalls. Consequently, many advisors prefer repayment mortgages to mitigate this risk.

However, an interest-only mortgage can serve as a practical short-term solution, especially if you plan to transition to a repayment mortgage as soon as your finances allow. In such cases, it is essential to provide all required documentation, just as you would if intending to keep the interest-only mortgage for its full term.

A prudent option is an interest-only mortgage that permits overpayments. This flexibility allows you to make additional payments when possible, reducing the capital balance. Many such mortgages are available and permit overpayments of 10% or more annually. Ensure, however, that any overpayments are permitted without penalties before finalizing your mortgage agreement.