According to Abbey, over a quarter of homeowners choose an interest-only mortgage. It's obvious why the payments are a lot more affordable, as this example shows: a 25 year £125,000 interest only mortgage at 5% costs £525 per month - but on a repayment mortgage it's an extra £210 a month, totalling £735 per month.
First time buyers are finding it tough enough to get on the property ladder as it is, so it's quite understandable that they should choose to take the option with the lower payments. However, a large proportion are not making enough provision for the time when they have to pay the capital off at the end of the mortgage term. In fact, 37% are failing to save enough money.
For this reason, the Financial Services Authority (FSA) has decided to step in and change the regulations. They now ask lenders to request firm evidence from new borrowers that they are saving a sufficient amount to cover the capital. Borrowers used to be able to say that they'd sell the property to raise the capital, but that will no longer be allowed. From now on, if an interest-only mortgage is sold and the application does not provide details of a savings vehicle to cover the capital the mortgage will be judged as being mis-sold. The lender would then be in trouble with the FSA for breaking regulations.
So what does the lender now need to see? They will expect to see either a personal equity plan (PEP) or an Individual Savings Account (ISA). You would also be able to use the 25% tax-free cash from a personal pension plan (PPP) to cover the capital. However, your savings vehicle will have to be in place and you must be able to provide proof of that simply saying that you're going to do it will not be good enough!
We have already seen that individual lenders are treating the FSA's new regulations in different ways. The Nationwide Building Society now say that repaying using an inheritance or depending on future pay rises will not be good enough. This is because they can't be guaranteed. Using a bonus scheme to cover the repayment will also only be counted if there is absolute proof that you will be able to achieve the required level of savings.
The above stipulations relate to first time buyers, existing homeowners can still get a Nationwide Building Society mortgage if the amount to be borrowed is less than two thirds of the new property's value, and there is £150,000 of net equity left in your current property.
Many mortgage advisers seem to agree that interest only mortgages are not the best option, and really should be treated as a last resort. With a repayment mortgage, you are guaranteed to pay off the mortgage by sticking to the repayment schedule, but a separate investment vehicle with an interest only mortgage could ultimately fail to deliver sufficient capital at the end of the term. It is a risk and many advisers will recommend a repayment mortgage to avoid that risk.
On the other hand, mortgage advisers do agree that interest only mortgages are very handy as a short term solution, and are more likely to support the decision if the borrower plans to switch to a repayment mortgage after four or five years. Even if it is only planned as a stop gap, the FSA will still expect the lender to get proof that a suitable investment or savings plan is in place, so you won't be able to pull the wool over anyone's eyes!
We think that the best way to help those that can only afford an interest only mortgage, is to point them towards a mortgage that allows them to make penalty free overpayments. That way, if they get some spare capital, they can actually pay some of it off, thereby reducing the outstanding mortgage. There are a wide variety of mortgages available like this, and the majority allow the borrower to repay 10% or more of capital each year, without having to pay any penalties. Of course, make doubly sure of this before you sign up for the mortgage.
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