How to stop an interest-only mortgage blowing up in your face
So what’s an interest-only mortgage?
An interest-only mortgage is exactly what the name suggests; a home loan where you only pay the interest that accrues and aren’t bound to pay off the amount you have borrowed until the end of the term.
Nearly one in five homeowners has one, and the people who use them range from those wishing to buy-to-let, people with other long-term savings or investment plans and simply those borrowers who view them as the most affordable way to buy.
They’re certainly the cheapest option to go for but they’re also potentially the riskiest. That’s because when you borrow the capital to buy your property using an interest-only mortgage, you still owe the lender this amount at the end of the term.
Here’s how the figures work out in real terms: You borrow £200,000 and decide to pay it off over 25 years. You manage to bag a fixed 2.5% interest rate for the entire mortgage term (unlikely, but let’s say you have for the sake of example). You’ll only pay £417 per month for the term.
Great, where do I sign? Just a second, not so hasty. Don’t forget that in 25 years time, you’ll be handed a bill for…you guessed it, £200,000. And during the course of your repayments, you’ll have paid the lender a total of £325,055 in interest alone. Now you know why bankers get such big bonuses.
So why do buyers go for this type of loan? Because it provides the freedom to pay off the mortgage amount at the end of the term; not just make larger monthly payments that pay off both the loan amount and the interest.
You can do this using various methods such as savings, investments (we’ll discuss these in more detail later) or from cashing in other assets.
Another option available is to sell the property and hope that prices have risen sufficiently to pay off the initial sale price and leave you with a bit on top for your trouble. This is the reason why interest-only mortgages are very popular with buy-to-let investors. The rental income covers the monthly payments, the final property sale covers the loan amount and you’re left with a tidy profit. That’s the theory, anyway.
Things are about to get very interesting…
But it seems the future is not looking bright for some interest-only borrowers. The Financial Conduct Authority (FCA) has recently warned that many homeowners are running the risk of losing the homes they’ve bought using interest-only mortgages as they haven’t made adequate financial provision to pay off the outstanding balance.
They estimate that 1.67 million full interest-only and part-capital repayment mortgages are still outstanding, representing 17.6% of all mortgages in the UK. Their figures also show that many of these mortgages are due to reach the end of their term in the next 10 to 14 years.
So if you have decided to go down the interest-only route (and let’s face it, this type of mortgage does make sense to help you move in with attractively low monthly repayments compared to a repayment mortgages) how do you make sure you’re not left looking at a repossession notice at the end of the term?
Things to do to make sure you’re not left high and dry
The mortgage lender will only lend an interest-only mortgage if you can demonstrate how you’ll repay the original loan. So here are a few boxes to consider ticking to avoid that ticking time bomb of an interest-only mortgage:
You won’t be able to rely on promises of future earnings or winning the lottery, so any cash needs to be from a savings account or ISA. Work out how much you’ll need to save over the mortgage term to match the initial capital amount and remember to add the interest you’ll earn. Don’t forget, interest rates will change and as of right now (early 2018), it looks like the only way is up. Good news for savers. And perhaps most importantly, don’t use these savings for anything else to avoid a nasty surprise.
These are investment products provided by life assurance companies. They work as regular savings plans and pay out a lump sum at the end of a set period. In the past, many interest-only mortgage lenders were misadvised about these and set up policies that didn’t perform as expected. Which meant that they couldn’t cover the loan amount at the end of the mortgage. Usually, they are now guaranteed to pay back a minimum amount provided as long as they are held to the end of the term, so they can be a good choice for regular savers who aren’t keen on sleepless nights.
Stocks and shares ISAs
Perfect if you don’t need access to your money and want to keep your money invested for a few years. That’s you, interest-only mortgage candidate. At the moment, you can pay up to £20,000 into an ISA each tax year and most of the income you make will be tax-free. But, there’s no such thing as a free lunch for us savers so because they are invested in the stock market, the value can go down as well as up. So, if you’re building up your mortgage fund this way, make sure you check on your ISAs regularly.
A pension is another way to save long-term and pay less tax, as you can’t normally get your hands on your pension pot until you are 55. The idea is that the fund you’ve built up will provide you with an income in your twilight years. It’s also a good way to build up a lump sum to pay off your mortgage. Many pensions offer a guaranteed lump sum if you keep up with your agreed payments. Generally, you can access the money in your pension pot from the age of 55.
These are investments where your money is locked away in your choice of funds, normally for a fixed term. They generally allow a small amount to be withdrawn each year. They require you to invest a minimum amount at the start (usually a minimum of £5000) which is tied up until the bond matures. These are a good option if you are risk averse, as many will guarantee that you won’t get back less than you originally invested. In this case, you can’t lose but you can expect to pay tax on any income they generate.
Bought and sold on the stock exchange, shares are where the big returns and even bigger risks lie. If you know what you are doing and enjoy a frisson of adrenaline when it comes to your personal finances, shares could be for you. Most financial advisers would recommend not just relying on them to cover your mortgage loan, but including them as part of your overall plan.
Unit trusts are managed share funds that pool resources and are managed by a (hopefully) competent financial pro. They’re a good choice if you want to invest in shares but don’t really feel confident doing it yourself, plus you can usually choose the level of risk you’re comfortable with. You’ll need to make regular contributions and can get the ball rolling with a small initial lump sum. You can normally sell your shares (or units as they are known) at any time.
Thinking of taking out an interest-free mortgage or any other type of mortgage? Visit Smoove Move to get some impartial advice from the moving experts, who can also help you negotiate every other step of your moving journey.