Mortgages. The Pitfall Of Interest Only Mortgages.

In the first three months of 2002, just 9% of all new mortgages were interest-only, but by the last quarter of 2005, this figure had risen to 23%. Amongst first-time buyers, the numbers increased from 6% to 15% (Source: Council of Mortgage Lenders).

The reason for this surge is clear: family economics. With an interest-only mortgage, monthly repayments cover only the ongoing interest, keeping payments low. Repayment of the capital borrowed is deferred to the end of the mortgage term when it must be repaid as a lump sum. This trend reflects borrowers' desire to minimize fixed monthly outgoings to maintain their lifestyle, enjoying nice cars, nights out, and holidays abroad. However, the reluctance to reduce lifestyle spending, combined with steadily rising house prices, could create future problems. If borrowers aren't repaying any of the capital now, how will they manage to repay it later?

Prompted by concerns from the Financial Services Authority (FSA), many lenders have become stricter when assessing applications for interest-only mortgages. They now insist on a viable repayment plan before approving the loan. These repayment vehicles might include the tax-free cash forecast from a pension policy, an ISA, or another regular investment or savings scheme. The risk is that borrowers might cancel their savings schemes after securing the mortgage.

If this happens, borrowers may face the need to sell their home and downsize to repay the mortgage capital when retirement arrives. This is a scenario both lenders and the FSA are eager to avoid.

Twenty years ago, interest-only mortgages were common, with endowment policies being the popular investment for repaying the capital. However, returns on endowment policies have not been as high as expected, leaving many homeowners with a capital repayment shortfall. Endowment policies have failed to be the "guaranteed" repayment solution many assumed they would be. Given today's economic and investment environment, it is difficult to be certain of any scheme to repay the capital.

As the shortcomings of endowment policies became apparent, interest-only mortgages fell out of favour, and repayment mortgages became the norm. But now the pendulum is swinging back. Interest-only mortgages are gaining popularity again due to high house prices and people's desire to get onto and move up the housing ladder without economizing on other spending areas.

Family finance pressures will likely continue to drive demand for interest-only mortgages. However, it is the responsibility of mortgage brokers and lenders to highlight alternative options to their clients.

Traditionally, a 25-year mortgage term was the norm for young buyers. Now, repayment periods can stretch to 30 or even 35 years, making repayment mortgages more affordable. For example, the monthly repayments for a £125,000 repayment mortgage over 25 years at 4.9% would cost £731.69 per month. Stretching the repayment period to 35 years drops the payment to £628.16 per month, saving £103.53 in cash flow.

Borrowers can make optional lump sum repayments as family finances permit, reducing the outstanding capital. In practice, people tend to move house every eight to ten years, and each move represents an opportunity to reassess long-term family finances.

Other solutions are available. For instance, arranging a mortgage where part of the loan is on a repayment basis and the balance on interest-only offers a midway option. This approach begins the repayment process, and when the family income grows or the borrower moves home, they can reassess the most suitable mortgage type.

It's important to avoid speculation when it comes to home finances. Mortgages are complex, and there is never just one solution. Professional advice is crucial; using a mortgage broker who can search the entire market is highly recommended.