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Warning over rise of the never-ending mortgage

Borrowers who take out interest-only loans could be landing their heirs with big debts, warns David Budworth

TENS of thousands of borrowers have taken out interest-only mortgages with no means of repaying their debt. And banks and building societies are resorting to ever more drastic measures to help stave off financial disaster, including controversial never-ending mortgages.
A decade of strong house-price growth has encouraged one in four borrowers to take out interest-only loans, where monthly repayments cover the interest to the lender but nothing goes towards repaying the capital, says the Council of Mortgage Lenders.

These mortgages can cut costs for first-time buyers and enable existing homeowners to move on to properties that would otherwise be out of their reach, because monthly repayments are lower.

However, lenders are growing increasingly concerned that many homebuyers are storing up trouble for the future because many have no means of repaying the original loan; borrowers are not usually required to have a repayment vehicle in place when they sign up.

Kent Reliance and Britannia building societies are writing to all their interest-only customers to remind them of the importance of having sufficient funds to repay the capital.

If they haven’t, Kent Reliance said last week, it would even consider allowing some borrowers to pass an unpaid mortgage to their children. The children would take on the debt, paying off the loan out of their own inheritance. Mike Lazenby, the society’s chief executive, said: “As long as we can be sure that the relatives won’t have a problem, we would consider it.”

This has raised the spectre of inter-generational mortgages, which became common in Japan in the 1990s when borrowers were saddled with record debts.

Research by Abbey reveals that one in three homeowners with an interest-only mortgage has no linked savings vehicle to pay off the capital. That is about one in every 12 borrowers.

Julia Harris at Moneyfacts, a research firm, said: “This could cause big problems in years to come. Borrowers may find they cannot afford to pay off the loan by the end of the term, leading possibly to mortgage defaults and, in the worst-case scenario, repossession.”

When house prices were soaring, many people who took out interest-only loans could rely on growth in the value of their property to clear the capital. But with house prices expected to be subdued over the next few years, some lenders believe radical action is now required.

Lenders will allow borrowers to extend their loan way beyond the typical 25-year term to 30, 40 or even 50 years if they cannot repay it over the standard period. But longer mortgages are controversial because borrowers end up shelling out more in interest and risk carrying bigger debts for longer.

A £100,000 interest-only mortgage at 5% would cost £125,000 in interest over 25 years, while the same mortgage over 40 years would cost £200,000 in interest.

Extending your interest-only mortgage will make no difference to your monthly repayments. With a repayment mortgage interest payments drop as you pay off the capital, but with an interest-only loan your capital remains the same and so does the interest on your repayments. Lenders offer it as an option to interest-only customers only so they have time to sort out an alternative.

Nick Gardner of Chase de Vere Mortgage Management, a broker, said: “Extending your mortgage should be avoided, if possible, because it doesn’t make financial sense. Paying off your mortgage on time will work out cheaper in the long run.”

But you need to be disciplined. Borrowers who plan to set up a savings vehicle to pay off the capital will almost certainly have to invest in the stock market, at least in the early years, to give their investment a chance to grow. They should make the most of tax-free schemes such as Isas.



If you invested £7,000 in an Isa every year for 25 years it would return about £400,000, assuming annual growth of 6%, according to Chelsea Financial Services, an adviser. If the investment achieved 10% growth it would return just over £750,000.
But it is still risky. The only way of guaranteeing you will own your home at the end of the mortgage term is to switch to a repayment mortgage, where you pay off part of the capital as well as the interest each month.

The earlier you make the move the better. Leave it too long and the jump from interest-only to capital repayment could be unaffordable.

If you have a 25-year, £100,000 mortgage and switch to a repayment loan after two years the monthly payments would rise from £417 to £610, assuming a 5% mortgage rate. If you made the switch after five years, you would pay £660 on the same rate, and if you waited for 15 years the payments would leap to £1,060.

Another option is part repayment, part interest only, which allows you to gradually build up the percentage of the capital that is paid off.

Alternatively, you could pay off chunks of the capital during the mortgage term, but make sure you have a flexible mortgage that allows you to do this without redemption penalties. Many lenders will allow borrowers to pay off up to 10% of the capital each year without charging a fee.

This is likely to be an appealing option if you work in a job that pays regular bonuses, or you expect big pay rises in future. It is also a good idea for self-employed people whose earnings fluctuate as they may pay off big sums when they are doing well. Repayments can be cut back during slack periods.

NO ILLUSIONS

FOR Nicola Haley, 28, an interest-only mortgage is the only way she and her boyfriend can afford to buy their first flat.

The couple will complete on the purchase in Bath later this month, and they are under no illusions about the risks they are taking.

Haley, who works in financial services, receives a large part of her salary in the form of bonuses and she intends to pay off chunks of the capital when she can.

The couple plan to move to a repayment mortgage, where they will pay off the interest and capital each month, in a few years’ time.

They realise that if they leave it too long, however, the jump in payments when they switch to a repayment vehicle could be a shock.

Haley said: ‘An interest-only loan suits our circumstances at present but we will switch to repayment as soon as we can.’
http://business.timesonline.co.uk/article/0,,9553-2319967_2,00.html